The Cost of Diversity: The Diversification Discount and Inefficient Investment

Posted: 11 Apr 2000

See all articles by Raghuram G. Rajan

Raghuram G. Rajan

University of Chicago - Booth School of Business; International Monetary Fund (IMF); National Bureau of Economic Research (NBER)

Henri Servaes

London Business School; Centre for Economic Policy Research (CEPR)

Luigi Zingales

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

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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.

JEL Classification: G31, L22

Suggested Citation

Rajan, Raghuram G. and Servaes, Henri and Zingales, Luigi, The Cost of Diversity: The Diversification Discount and Inefficient Investment. Journal of Finance, Vol. 55, No. 1, February 2000, Available at SSRN: https://ssrn.com/abstract=217749

Raghuram G. Rajan (Contact Author)

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Luigi Zingales

University of Chicago - Booth School of Business ( email )

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