Working Paper: CEPR ID: DP1801
Authors: Raghuram G. Rajan; Henri Servaes; Luigi Zingales
Abstract: In a simple model of capital budgeting in a diversified firm where headquarters have limited power, we show that funds are allocated towards the most inefficient divisions. The distortion is greater, when the investment oppotunities of the firm?s divisions are more diverse. We test these implications on a panel of diversified firms in the United States during the period 1979?93. We find that i) diversified firms mis-allocate investment funds; ii) the extent of mis-allocation is positively related to the diversity of investment opportunities across divisions; and iii) the discount, at which these diversified firms trade, is positively related to the extent of the investment mis-allocation and to the diversity of investment opportunities across divisions.
Keywords: diversification; capital budgeting; conglomerate
JEL Codes: G31; L22
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Poor investment opportunities (G19) | Higher resource allocation (D29) |
| Higher resource allocation (D29) | Diversification discount (G19) |
| Diversity of investment opportunities (G11) | Higher resource allocation (D29) |
| Misallocation of funds (D61) | Diversification discount (G19) |
| Diversity of investment opportunities (G11) | Diversification discount (G19) |