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The Cost of Diversity: The Diversification Discount and Inefficient Investment

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Author Info
Rajan, Raghuram G
Servaes, Henri
Zingales, Luigi

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Abstract

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.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 1801.

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Date of creation: Mar 1998
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Handle: RePEc:cpr:ceprdp:1801

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Related research
Keywords: capital budgeting; conglomerate; Diversification;

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Find related papers by JEL classification:
G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Investment Policy
L22 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Firm Organization and Market Structure

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  14. Karl Lins & Henri Servaes, 1999. "International Evidence on the Value of Corporate Diversification," Journal of Finance, American Finance Association, vol. 54(6), pages 2215-2239, December. [Downloadable!] (restricted)
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