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The Cost of Diversity: The Diversification Discount and Inefficient Investment

  • RAGHURAM RAJAN
  • HENRY SERVAES
  • LUIGI ZINGALES

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.

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Paper provided by Center for Research in Security Prices, Graduate School of Business, University of Chicago in its series CRSP working papers with number 463.

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Handle: RePEc:wop:chispw:463
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