The Cost of Diversity : The Diversi cation Discount and Ine cient Investment

We model the distortions that internal power struggles can generate in the allocation of resources between divisions of a diversi ed rm. The model predicts that if divisions are similar in the level of their resources and opportunities, funds will be transferred from divisions with poor opportunities to divisions with good opportunities. When diversity in resources and opportunities increases, however, resources can ow towards the most ine cient division. This leads to more ine cient investment and less valuable rms. We test these predictions on a panel of diversi ed rms in the U.S. during the period 1980 to 1993 and nd evidence consistent with them. The fundamental question in the theory of the rm, raised by Coase (1937) more than 60 years ago, is how do decisions taken inside a hierarchy di er from those taken in the marketplace. Coase suggested that decisions within a hierarchy are determined by power considerations rather than relative prices. If this is indeed the case, why, and when, does the hierarchy dominate the market? A major obstacle to progress in this area has been the lack of data. Data on internal decisions made by rms are generally proprietary. Even when they are available to researchers, it is di cult to nd a relevant comparison group of decisions taken in the market. A notable exception is the capital allocation decision in diversi ed rms. Since 1978, public U.S. companies have been forced to disclose their data on sales, pro tability, and investments by major lines of business (segments). An analysis of a small sample of multi-segment rms reveals that segments correspond, by and large, to distinct internal units of the rm. Since the investment decision is perhaps the most important of corporate decisions, these data allow researchers an opportunity to compare decisions taken by units within hierarchies with decisions taken by independent units in the same industry, and thus obtain insights on how hierarchies and markets di er. Previous research (Lamont (1997) and Shin and Stulz (1998)) has shown that resource allocation in diversi ed rms does appear di erent from that in focused rms and seems to ignore traditional market indicators of the value of investment such as Tobin's q. Moreover, there seems to be a connection between resource (mis-)allocation and the value of diversi ed rms. Berger and Ofek (1995) nd that investment by diversi ed rms in segments that have low q is correlated with the discount at which these rms trade. So perhaps such misallocation