This study investigates the importance of reduced capital misallocation in explaining the gains in corporate spinoffs. The capital misallocation hypothesis asserts that the internal capital market of a diversified firm fails to meet the needs of the relatively low growth divisions for less investment and the needs of the relatively high growth divisions for more investment. Higher differences in growth opportunities imply that more capital is misallocated. This study finds that the higher the difference in growth opportunities of a diversified firm's businesses, the more likely the firm is to conduct a spinoff. This finding supports the argument that diversified firms conduct spinoffs to reduce capital misallocation. This study finds differences in managerial ownership of spinoff firms and of nonspinoff firms. This suggests that the misallocation of internal capital is an agency problem. A low management ownership stake, coupled with the existing differential in growth opportunities between parent and spunoff firms, leads to misallocation of internal capital, thus creating incentives for a spinoff. Spinoffs should result in a shift to the “right" investment policy and to better operating performance for both the parent and spunoff firms. This improvement in operating performance for the post-spinoff firms is expected to be higher …