Coinsurance and the Corporate Cost of Capital

Abstract

We empirically examine how coinsurance induced by diversification affects a firm’s cost of capital and its key determinants. Our newly developed coinsurance measure explicitly captures the default risk connectedness across a firm’s business segments and hence the very source of coinsurance. We find that firms with higher coinsurance display a lower cost of debt or higher leverage, with the chosen trade-off predictably varying with a firm’s financial constraint. Coinsured firms exhibit a higher cost of equity, except those with intermediate financial constraints. Overall, coinsurance relates to a lower cost of capital for the latter. Highly constrained firms face a markup.

Keywords: diversification, coinsurance, cost of capital, default risk connectedness, financial constraint

JEL Classification: G32, G33, L25