This study investigates the effects of internal business transactions on stock prices in Korean business groups. Large business groups, better known as chaebol organizations (or simply chaebol) have long engaged in internal business transactions. Internal Business transactions include the sale and purchase of goods, the provision and receipt of mortgages, the provision and receipt of loan guarantees and the lending and borrowing of funds among group members.

Internal business transactions have been recognized as a source of the inefficiency of Korean firms, and the inefficiency of Korean firms has been blamed to be in part responsible for the 1997 financial crisis. However, if internal business transactions have been a mode of business for an extended period of time in Korean business groups, there must also have been some positive aspects of such activities.

Controversies surrounding internal business transactions center on whether or not such activities contribute to the inefficiency of business firms. There are two opposing views on the effects of internal business transactions on firm value and stock prices. Several authors including Williamson(1975) argue that internal business activities could enhance the efficiency of firms by reducing transactions costs involving the purchase and sale of intermediate goods among group members. However, the majority of authors maintain that internal business transactions are used as a means of cross subsidization among member firms, thus enabling inefficient firms to survive in the market.

More recent studies have emphasized the importance of ownership concentration and legal protection in the determination of firm value. Thus, it is not straightforward to draw conclusive relations between internal business transactions and firm value (or stock prices) on the theoretical basis.

The purpose of this study is two-fold : We first develop a theoretical model which addresses the relationship between stock valuation and internal business variables in the context of the agency problem(=information error model). Second, we conduct an empirical analysis of our information error model. Our information error model relates current stock prices to stock prices in the previous period, current dividends, and the determining variables of internal business transactions. We also introduce a return variable, a size variable(assets), and dummy variables which represent the 30 largest business groups and different time periods.

The data used in this study consist of the unbalanced data set from 1991 to 2000 which includes 590 business firms listed on the Korean Stock Exchange. Thus, we have 4,844 observations. We have found that the provision and receipt of mortgages, the asset variable, the return variable, and the 30 largest group dummy are all significant determinants of stock prices at the 5 percent level of significance, but the provision and receipt of loan guarantees, the purchase and sale of goods among group members, and the lending and borrowing of funds among group members turned out to be insignificant.

The estimated coefficients have mixed signs, some of which appear to be at variance with our common perception. In particular, the receipt of mortgages and loan guarantees, the borrowing of funds and the sale of goods are expected to have positive effects on stock prices, but they have all negative effects, although most of the coefficients are insignificant at the conventional level of significance, except for the coefficient of the receipt of mortgages. These seemingly contradictory results seem to stem from the fact that the firms which receive mortgages, and loan guarantees, borrow funds, and sell goods to other group members were typically small in size and poorly performed. Thus, the market evaluates these activities negatively.

We have also found that the chaebul such as the 5 largest business groups or the 30 largest business groups have enjoyed some premium in their stock prices.

In a separate study, Park(2001) has found that internal business transactions had the effect of reducing the inefficiency of firms. This seeming contradiction could be attributed to the fact that the Korean stock market is not efficient in the Fama sense, which is supported by Yuhn(1997).