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The Cost of Diversity: The Diversification Discount and Inefficient Investment

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  • Raghuram Rajan
  • Henri Servaes
  • Luigi Zingales

Abstract

In a simple model of capital budgeting in a diversified firm where headquarters has limited power, we show that funds are allocated towards the most inefficient divisions. The distortion is greater the more diverse are the investment opportunities of the firm's divisions. We test these implications on a panel of diversified firms in the U.S. during the period 1979-1993. We find that i) diversified firms mis-allocate investment funds; ii) the extent of mis-allocation is positively related to the diversity of the investment opportunities across divisions; 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 the investment opportunities across divisions.

Suggested Citation

  • Raghuram Rajan & Henri Servaes & Luigi Zingales, 1998. "The Cost of Diversity: The Diversification Discount and Inefficient Investment," NBER Working Papers 6368, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:6368
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    More about this item

    JEL classification:

    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • L22 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Firm Organization and Market Structure

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