Corporate Diversification and the Cost of Capital

Abstract:     
We examine whether organizational form matters for a firm's cost of capital. Contrary to the conventional view, our model shows that coinsurance among a firm's business units can reduce systematic risk through the alleviation of countercyclical deadweight costs. Using measures of implied cost of capital constructed from analyst forecasts, we find that diversified firms have on average a lower cost of capital than stand-alone firms. In addition, diversified firms with less correlated segment cash flows have a lower cost of capital, consistent with a coinsurance effect. Holding the magnitude of cash flows constant, our estimates imply an average value gain of approximately 6% when moving from the highest to the lowest cash flow correlation quintile.

Keywords: Corporate diversification, Coinsurance, Cost of capital

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