Ch. 8: Conglomerate Firms and Internal Capital Markets 425
- Introduction
In this chapter we survey the large literature on corporate diversification in corpo-
rate finance. For corporate finance, the primary questions about diversification are:
“When does corporate diversification affect firm value?” And, “When diversification
adds value, how does it do so?” By a diversified firm in corporate finance, we usu-
ally mean a firm that operates in more than one industry, as classified by the Standard
Industrial Code (SIC).^1
Questions about the relation between diversification and value arise naturally from
the larger problem of determining how the boundaries of firms should be set.Coase
(1937)argues that boundaries are set at the point at which the costs of carrying out
transactions within a firm equal those of carrying them out in the open market or in
another firm. Thus, for corporate diversification to be of interest, it must be that the
cost of carrying out transactions within the firm are affected if it contains more than
one industry within its boundaries. Implicit in this belief is that the skills and resources
which are required to operate efficiently differ materially across industries, and that the
diversityof operating environments affects the cost of performing transactions within
the firm. These cost differences could be due to financial externalities across industries,
such as improved risk sharing within the firm, or real externalities that could arise due
to the use of a shared factor of production, such as the attention of the firm’s decision
makers.
Diversification across industries is also of interest to researchers because data on
most intra-firm decisions is in general hard to acquire. By contrast, some data on how
firm revenues and capital expenditures are distributed across the industries is readily
available, which makes the research on diversification a good starting point for studying
the more general problem of setting firm boundaries.
A more pragmatic reason for studying corporate diversification is that corporate man-
agers face decisions about diversifying and refocusing their firms. In addition, managers
face decisions about investing across multiple businesses they operate. Companies such
as Berkshire Hathaway and General Electric generate large amounts of cash that can be
invested in different business or returns to shareholders via dividends. Empirical data
about how such decisions worked out in the past may be useful in strategic planning.
Estimates of specific of costs and benefits might also be useful to investors and to regu-
lators.
The corporate finance literature on diversification took off with the discovery of the
conglomerate discount byLang and Stulz (1994)andBerger and Ofek (1995).Ourre-
view therefore begins with a discussion of these papers and of subsequent work that
has extended and reinterpreted their results. We then briefly discuss the theoretical
(^1) In practice, researchers usually define firms as diversified if they generate less then 90% of their revenues
in a single SIC code industry. Industries are commonly defined at the 3-digit level, although some studies
use the 2-digit or 4-digit levels.Scharfstein (1998)is an exception in using a more qualitative criterion for
diversification.