A Simultaneous Examination of Two Competing Explanations for the Corporate Diversification Discount

Inefficient internal capital markets and the coinsurance effect are two potential explanations for why firms with multiple business segments exhibit a value discount relative to single business segment firms.Previous research labels the difference in value a diversification discount and provides some support for both explanations.However, most studies examine the effects separately so it is difficult to determine their relative significance.We examine the two potential explanations simultaneously using fixed firm effect regressions.We use a measure of the diversity of a firm's investment opportunities to proxy for inefficient internal capital markets, and we use an interaction term involving leverage and risk to proxy for the coinsurance effect.Our results indicate a statistically significant negative relationship between firm value and the diversity in investment opportunities variable which indicates that inefficient internal capital markets are an important determinant of the diversification discount.The results suggest a negative relationship between firm value and the proxy for the coinsurance effect, but the relationship is not statistically significant in all tests.