Exploring the Relationship Between Firm Diversification and Productivity

Corporate diversification was popularized by conglomerates in the 60s and 70s (Lang & Stultz 1994). It is a strategy that involves choosing to structure a company operation in such a way that it promotes involvement in a wide range of revenue producing activities. This could involve production of goods and services associated with the business, or focusing more on how the company chooses to arrange its investment portfolio. The goal of diversification in any industry is to diversify production and assets over a range of activities, thereby increasing the chances of returns while also minimizing the potential for failure or loss.
The objective of this study is to examine intricately the relationship between firm diversification and productivity

While Bhide (1990) suggests that the difference lies in the dealings of customers, suppliers, lenders, and tax authorities with the diversified firm are affected by the aggregated fortunes of its constituent businesses and the additional level of administrative or corporate overhead, we see that there are three main reasons for diversification. First, Lewellen’s financial theory of corporate diversification (1971) argues that diversification at the firm level leads to a reduction in variance of future cash flows thus increasing the debt capacity of the diversified firm. He concludes that as long as debt capacity adds value, diversification is a source of added value. Secondly, diversified firm’s cash flows provide a superior means of funding an internal capital market which offers a number of possible sources of value to the firm’s owners as internally raised equity capital is cheaper than funds raised in the external capital market and this gives the firm’s managers superior decision control over project selection, rather than forcing them to base the firm’s investment decisions to perceptions less-informed investors in the external capital market. This was formally put forth by Stein (1997), who suggests that managers select better projects as they have superior information. Finally, Khanna and Palepu (1999) propose

In this paper, we find a negative relationship between diversification and productivity of the firm. Also, the optimal number of 4-digit industries for a firm to be involved in, assuming the firm is considering the diversification strategy, is found to be 5.4. We find that the mean return on equity and mean return on assets for firms who are involved in lesser than 5 4-digit industries is lower than the same for firms who are involved in greater than 5 4-digit