The Cost of Diversity: The Diversification Discount and Inefficient Investment Raghuram Rajan, Henri Servaes, and Luigi Zingales NBER Working Paper No. 6368 January 1998 JEL Nos. G31, L22 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. Raghuram Rajan Graduate School of Business University of Chicago 1101 East 58th Street Chicago, IL 60657 and NBER Rajan@gsbux1.uchicago.edu Luigi Zingales Graduate School of Business University of Chicago 1101 East 58th Street Chicago, IL 60657 and NBER Luigi@gsblgz.uchicago.edu http://gsblgz.uchicago.edu Henri Servaes Kenan-Flagler Business School University of North Carolina at Chapel Hill Carroll Hall - CB3490 Chapel Hill, NC 27599 Servaesh.bsacd1@mhs.unc.edu Research on corporate diversification has generated an interesting puzzle. On the one hand, theoretical models typically suggest that diversification creates value. By forming an internal capital market where the internally generated cash flows can be pooled, diversified firms can allocate resources to their best use (Weston (1970), Williamson (1975)). More recently, Stein (1997) argues that diversified firms can enhance efficiency because they fund winners and abandon losers in a way that the financial market may not be able to do with stand-alone firms. By contrast, recent empirical work seems to suggest that diversification destroys value. Morck, Shleifer, and Vishny (1990) show that acquiring firms experience negative returns when they announce unrelated acquisitions. Lang and Stulz (1994) and Berger and Ofek (1995) find that diversified firms trade at a discount of at least 13 to 15 percent relative to a portfolio of single-segment firms in the same industries. There is also indirect evidence that the internal capitalThe Cost of Diversity: The Diversification Discount and Inefficient Investment Raghuram Rajan, Henri Servaes, and Luigi Zingales NBER Working Paper No. 6368 January 1998 JEL Nos. G31, L22 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. Raghuram Rajan Graduate School of Business University of Chicago 1101 East 58th Street Chicago, IL 60657 and NBER Rajan@gsbux1.uchicago.edu Luigi Zingales Graduate School of Business University of Chicago 1101 East 58th Street Chicago, IL 60657 and NBER Luigi@gsblgz.uchicago.edu http://gsblgz.uchicago.edu Henri Servaes Kenan-Flagler Business School University of North Carolina at Chapel Hill Carroll Hall - CB3490 Chapel Hill, NC 27599 Servaesh.bsacd1@mhs.unc.edu Research on corporate diversification has generated an interesting puzzle. On the one hand, theoretical models typically suggest that diversification creates value. By forming an internal capital market where the internally generated cash flows can be pooled, diversified firms can allocate resources to their best use (Weston (1970), Williamson (1975)). More recently, Stein (1997) argues that diversified firms can enhance efficiency because they fund winners and abandon losers in a way that the financial market may not be able to do with stand-alone firms. By contrast, recent empirical work seems to suggest that diversification destroys value. Morck, Shleifer, and Vishny (1990) show that acquiring firms experience negative returns when they announce unrelated acquisitions. Lang and Stulz (1994) and Berger and Ofek (1995) find that diversified firms trade at a discount of at least 13 to 15 percent relative to a portfolio of single-segment firms in the same industries. There is also indirect evidence that the internal capital