RFS Advance Access originally published online on September 28, 2007
Review of Financial Studies 2007 20(6):1901-1940; doi:10.1093/rfs/hhm047
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Strategic Cost of Diversification
Rice University
Address correspondence to Evgeny Lyandres, Jones Graduate School of Management, Rice University, Houston, TX 77005, or e-mail: lyandres{at}rice.edu
JEL: G32, G34, L13
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Abstract |
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This article proposes a new explanation for the large cross-sectional variation in the excess values of diversified firms. The model applies the idea of shareholders' limited liability affecting firms' output market strategies to the analysis of financial and operating choices of conglomerates. The inability of conglomerates to commit to unconstrained optimal operating strategies, following from the lack of flexibility in choosing their divisions' capital structures, reduces their value. Thus, the model highlights a new type of inefficiency of the conglomerate organizational structure, which is suboptimal financing. The predictions of the model are generally supported by the data.
I would like to thank an anonymous referee, Robert McDonald (the editor), Rui Albuquerque, Mike Barclay, Gennaro Bernile, Mark Bils, Jim Brickley, Gustavo Grullon, Ronald Jones, Erwan Morellec, Bill Schwert, Cliff Smith, James Weston, Alexei Zhdanov, and seminar participants at Ben Gurion University, Hebrew University, HEC Montreal, Norwegian School of Management BI, Tel Aviv University, University of California at Riverside, University of Rochester, and University of Utah for very helpful comments and suggestions. All remaining errors are mine only.