Corporate diversification, investment flexibility and internal capital markets

The objective of this thesis is to understand the effect of corporate diversification on the selection of growth options with relevant implications for firm value. This is achieved by undertaking a theoretically grounded empirical analysis in three separate empirical studies, namely the “investment flexibility” of diversified firms in the selection of growth options, the impact of “financial constraints” that arise from the efficiency of internal capital markets, and finally, the implications of both investment flexibility and the efficiency of internal capital markets for firm value in the context of global diversification. The first study examines the “investment flexibility” of diversified firms in the selection of growth options versus focused firms. Investment flexibility points to the ability of a firm to manage its systematic risk by optimally selecting and exercising growth options available to it. In a portfolio context, the scope of growth options accessible to a firm is constrained to the business segments in which it participates. Firms participating in a larger number of business segments can opportunistically select growth options to optimize the systematic risk of its cash flows from capital investments. Consistent with this interpretation, empirical results show that diversified firms have more investment flexibility than focused firms to select growth options with lower systematic risk. However, the benefits of investment flexibility are limited to states when both diversified and focused firms have few growth options available. The second study discusses the implications for firm value due to financial constraints attributable to the efficiency of an internal capital market (ICM) within a diversified firm. ICMs offer the advantage of relaxing financial constraints for capital investment through the avoidance of costly external capital markets. ICM are also criticized for funding inefficient investment due to the insulation of management from the discipline of external financial markets. Recent studies show that financial constraints are a source of risk that is priced in stock returns. This suggests a positive constraints-return relation between the efficiency of a diversified firm’s ICM and stock returns. Empirical results confirm this relation and show that ICM efficiencies are priced in asset markets. In addition, firm characteristics such as total asset growth and asset tangibility are documented to have a positive and significant relation with ICM efficiency. In contrast, a significantly negative relation between ICM efficiency and intangible assets is documented. Finally, the third study examines the implications that both investment flexibility and financial constraints arising from ICM efficiency have for firm value within the context of global diversification. Hypothetically, global diversification potentially enhances investment flexibility as firms can select growth options from both a variety of industries and geographic markets. A lower correlation of internal funds due to the diversification benefit of cash flows from different countries could also potentially increase ICM efficiency. However, the results suggest otherwise. In comparison with firms that operate in only one geographic market, globally diversified firms do not have greater investment flexibility to select growth options with lower systematic risk nor do they have ICMs that are more efficient in reducing financial constraints. Consistent with observation that the global economy is economically and financially integrated, the evidence suggests that industry effects dominate country effects for both investment flexibility and ICM efficiency