The Cost of Diversity: The Diversification Discount and Inefficient Investment

We model the distortions that internal power struggles can generate in the allocation of resources between divisions of a diversified firm. 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 f low toward the most inefficient division, leading to more inefficient investment and less valuable firms. We test these predictions on a panel of diversified U.S. firms during the period from 1980 to 1993 and find evidence consistent with them. THE FUNDAMENTAL QUESTION IN THE THEORY of the firm, raised by Coase ~1937! more than 60 years ago, is how decisions taken inside a hierarchy differ 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 firms are generally proprietary. Even when they are available to researchers, it is difficult to find a comparable group of decisions taken in the market. A notable exception is the capital allocation decision in diversified firms. Since 1978, public U.S. companies have been forced to disclose their data on sales, profitability, and investments by major lines of business ~segments!. An analysis of a small sample of multisegment firms reveals that segments correspond, by and large, to distinct internal * Rajan is from the University of Chicago, Servaes is from the London Business School and University of North Carolina at Chapel Hill, and Zingales is from the University of Chicago. Rajan and Zingales acknowledge financial support from the Center for Research on Security Prices at the University of Chicago. Servaes acknowledges financial support from the O’Herron and McColl faculty fellowships, University of North Carolina at Chapel Hill. Comments from Sugato Bhattacharya, Judy Chevalier, Glenn Ellison, Milton Harris, Steven Kaplan, Owen Lamont, Colin Mayer, Todd Milbourn, Vikram Nanda, Jay Ritter, René Stulz, Robert Vishny, Ralph Walkling, Wanda Wallace, two anonymous referees, and especially Mitchell Petersen are gratefully acknowledged. Comments from participants in seminars at AT Kearney ~London!, the University of Chicago, Cornell University, the University of Georgia, the University of Florida, the University of Illinois, the London School of Economics, New York University, Northwestern University, Ohio State University, the College of William & Mary, Vanderbilt University, and Yale University were useful. THE JOURNAL OF FINANCE • VOL. LV, NO. 1 • FEBRUARY 2000