DP1801 The Cost of Diversity: The Diversification Discount and Inefficient Investment

Author(s): Raghuram G Rajan, Henri Servaes, Luigi Zingales
Publication Date: March 1998
Keyword(s): capital budgeting, conglomerate, Diversification
JEL(s): G31, L22
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=1801

In a simple model of capital budgeting in a diversified firm where headquarters have limited power, we show that funds are allocated towards the most inefficient divisions. The distortion is greater, when the investment oppotunities of the firm?s divisions are more diverse. We test these implications on a panel of diversified firms in the United States during the period 1979?93. We find that i) diversified firms mis-allocate investment funds; ii) the extent of mis-allocation is positively related to the diversity of investment opportunities across divisions; and iii) the discount, at which these diversified firms trade, is positively related to the extent of the investment mis-allocation and to the diversity of investment opportunities across divisions.