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An internal capital market is both a capital allocation method and a department within a company that disperses money to other sections of the company. Unlike an external capital market, an internal capital market owns the sections of the company to which it is giving money, which increases control of the funds. One advantage of owning the business units is that it is much easier to monitor those who receive the money, which may reduce the chances of fraud. Another advantage is that the department can change the allocation if the money is being used improperly.
There are two types of capital markets: external and internal. With an external capital market, the money is loaned to outside people and businesses that are not associated with the company giving out the money. In an internal capital market, the money is being sent to business units the company owns, which usually increases control over the funds unless there are unscrupulous employees attempting to steal the money. An external market makes money by charging interest on the borrowed money, while an internal market makes money through the projects and work done with the money.
One advantage to using this approach is that the money is much easier to track than if the money were being used by entities outside the company. For example, the department can talk with and check on the business unit’s expenditures to ensure the money is being used properly, and it can tell the unit how it can and cannot spend the money. The department also will know exactly who is handling the money and exactly where it is going, which can reduce the chances of fraud.
Allocation does not have to be static with an internal capital market, and it rarely is. The allocation of money normally is dependent on how well the business unit is doing, which makes it easier for the department to reward successful units and limit capital for unsuccessful units. For example, if a business unit is doing poorly and cannot bring in profits, then the allocation for that unit will decrease or entirely stop. The money would then go to more successful units to help bring in more money for the company.
Extra workers may be needed with an internal capital market, which may drive up costs. These extra workers ensure the money is being allocated and monitored correctly. With large companies, this can drive up the cost a lot, because many people may be needed to adequately watch the business units.