Internal and external control mechanisms can be collectively employed to address the conflicting interests of firm managers, shareholders, and other stakeholders. This dissertation includes three separate studies that examine the operating and market performance implications of external market-based and regulatory controls as well as internal controls, as defined by Jensen (1993). The scope of the control issue is expanded to include a more comprehensive definition of internal control as suggested by the Committee of Sponsoring Organizations of the Treadway Commission (COSO 1992). Firm environment may dictate whether an alignment of internal and external control mechanisms will produce operating and market benefits. Conversely, misalignment may result from overinvestment in internal controls or from ineffective external controls. This dissertation represents an initial attempt to shed light on the trade-offs that are made between internal and external controls and demonstrate how these trade-offs may vary depending on firm environmental setting, as reflected in the operating and market performance effects.;The first of these three studies considers the alignment of management control systems (internal control) and the market for corporate control (external control) in two distinct external environments characterized by high-growth and low-growth. In a sample of 1,693 firm-year observations over the 2000--2006 period, the research design creates four quadrants which represent differential degrees of internal and external control, and then tests for corresponding operating and market performance effects. While the results suggest that firms in high-growth industries will benefit operationally from a mix of controls that favors external controls, firms in low-growth industries benefit operationally from a control mix that favors internal controls. In addition, the results suggest that the equity market tends to favor a control mix more heavily weighted toward internal controls for firms in low-growth industries, but that same alignment is negatively viewed by the equity market for firms in high-growth industries. In contrast, the debt market generally favors a control mix that favors internal controls, regardless of industry growth characteristics, suggesting that debt market participants may not generally value external market control forces.;The second of these three studies examines the operating and market performance effects of the alignment of internal and external control mechanisms in a sample of 498 electric utility firm-year observations over the 2000--2006 period. Consistent with Stigler's (1971) argument that there is a demand for regulation, the results indicate that market valuation of equity is directly related to the degree of regulation. Furthermore, in this rate-regulated setting, over-investment in management control systems presents a significant risk, and this study finds that regulation increases the effect of free cash flow on investment in management control systems, given price-based regulation in this industry.;The third of these three studies examines the post-merger operating and market performance effects associated with pre-merger alignment of internal and external controls in 123 acquiring firms within a sample of 283 bank mergers and acquisitions over the 2000--2006 period. The results suggest that operating performance benefits associated with pre-merger controls may take longer to be realized. In addition, the results of this third study suggest that post-merger equity market valuation is inversely related to pre-merger regulation (external control) consistent with the notion that regulatory oversight may limit a firm's investment opportunities and prevent wealth maximization for firm shareholders. Finally, the negative relation noted between debt ratings and high internal and external controls suggests that the debt market discerns an overinvestment in controls that has negative future cash flow implications.;Taken together, these studies provide evidence that differential operating and market performance effects are associated with the alignment of internal and external controls, and further, these effects vary depending on firm environment. In sum, the results from the first paper provide evidence that the preferable alignment of internal and external controls depend on the growth characteristics of the firm's industry and the capital structure of the firm. Furthermore, the results from the industry settings in the second and third studies indicate potential overinvestment in control systems and other potential perverse incentives associated with regulatory oversight. These collective findings should be of interest to regulators, firm managers, equity shareholders, debtholders, and other stakeholders, given the current regulatory emphasis on comprehensive control systems that purport to mitigate agency conflicts between managers and other firm stakeholders.
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