Diversification and the value of internal capital markets: The case of tracking stock

Diversified firms trade at a discount relative to comparable portfolios of stand-alone firms. One explanation is that these firms have inefficient internal capital markets. We examine the link between firm value and the value of internal capital markets using a new form of corporate restructuring called tracking stock, We present a model that illustrates that the announcement effect of a tracking stock equity restructuring conveys information about the market's assessment of the value of a firm's internal capital market. We develop a measure of the profitability of the internal capital market, and we find a strong positive relation between it and tracking stock announcement effects, a finding consistent with our model. (C) 2000 Elsevier Science B.V. All rights reserved. JEL classification: G14; G30; G32; G34.