Diversification Discount, Information Rents, and Internal Capital Markets

Abstract

While many existing studies report that corporate diversification destroys shareholder value, two recent studies challenge these findings. Schoar (2002) finds that plants in conglomerates are more productive than those in comparable single-segment firms, although conglomerates are traded at discounts. Villalonga (2004) employs a more comprehensive database than that used in the existing studies, and shows that there is a significant diversification premium, rather than discount. This paper develops a model that highlights the costs and benefits of corporate diversification. The diversified firm trades off the benefits of more efficient resource allocation through its internal capital market against the costs of information rents to division managers, which are necessary for effective workings of the internal capital market. We provide an argument supporting Schoar's findings, and identify conditions under which there can be a diversification discount or a premium.

Keywords: Diversification discount, information rents, internal capital market, multidivisional firm, single-segment firm

JEL Classification: G30, J30