A Diversification Discount with Efficient Internal Capital

The effects of corporate diversification on firm value have been extensively investigated in the field of finance. The conventional wisdom is that a diversification discount results from inefficient internal capital allocation. This paper suggests that it does not necessarily hold in a signaling game model in which the types of the firm can have a significant impact on the bankruptcy risk. Under information asymmetry, single firms invest only in projects with high net present values (NPVs) or fall into bankruptcy. By contrast, diversified firms with efficient internal capital markets invest in a broader set of projects with positive NPV. Consequently, this indicates that the average values of surviving single firms can be higher than that of a diversified firm. This study contributes to the literature in three ways. First, we show that under viable conditions, a diversification discount can occur even with efficient internal capital. Second, our study suggests a theoretical basis which takes into account survivor bias in gaining a better understanding of a diversification discount. Third, this study provides a means through which both diversification discount and premium can be explained within one framework.