Corporate Diversification and the Cost of Capital
88 Pages Posted: 21 Mar 2009 Last revised: 25 Oct 2012
Date Written: October 24, 2012
We examine whether organizational form matters for a firm's cost of capital. Contrary to conventional view, we argue that coinsurance among a firm's business units can reduce systematic risk through the avoidance of countercyclical deadweight costs. We find that diversified firms have on average a lower cost of capital than comparable portfolios of standalone firms. In addition, diversified firms with less correlated segment cash flows have a lower cost of capital, consistent with a coinsurance effect. Holding cash flows constant, our estimates imply an average value gain of approximately 5% when moving from the highest to the lowest cash flow correlation quintile.
Keywords: Corporate diversification, Coinsurance, Cost of capital
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