Corporate governance, internal capital market, and firm value

Abstract

In the study, I first analyze Korean chaebols as one decision unit where controlling parties centrally influence investment and financing decisions of member firms. Borrowing the methodology used in the literature of diversification study in the U.S., I find that the mean and median excess values of member firms are positive and the aggregate excess value of the chaebol is non-negative. I find that a higher ratio of cash flow rights relative to control rights of controlling parties increases the value of internal capital markets and the group excess value in the post Asian crisis period of 1998-2001. Then, I examine the relationship between the controlling shareholder``s cash flow rights and the funds transfer inside the internal capital market of Korean business groups during the period from 1998 to 2001. I find that the funds allocation in the firms where controlling shareholders have high cash flow rights is better aligned with the investment opportunities and therefore, more efficient than in the firms where they have low cash flow rights. This effect is stronger when they have controlling powers large enough to expropriate minority shareholders. However, during the financial crisis period, funds simply move toward the firms where controlling shareholders have high cash flow rights. The results evidence the tunneling behavior in the internal capital market within a chaebol that the ownership structure distorts the allocation of internal funds in such a way as to benefit the controlling shareholders. Agency problems can become more serious during an economy-wide financial crisis and they can have different roles depending on the corporate governance structure of a company. Finally, I therefore examine whether agency problems explain the performance of Korean companies during the Asian financial crisis and whether agency problems explain the performance differently for chaebol vs. nonchaebol firms. Korean business groups, chaebols, are known to have weaker co...