Diversification Definition

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By theory, opinions of managers, creditors, and stockholders differ greatly regarding the merits of corporate diversification. For example, managers may want their firm to engage in diversification as a means of reducing firm specific risk that affects the value of their future compensation. Similarly, the firm’s creditors may prefer that the firm diversify its investments to reduce the likelihood of a dip in cash flows that could result in delays in repayment or outright failure to repay loans. At the same time, stockholders who own diversified portfolios of common stocks may not want the firm to diversify if they can do it more cheaply in their individual investment portfolios. From the point of view of the diversified stockholder, when we …show more content…

2001). However, evidence on the effectiveness of diversification is mixed. In the earlier years, there was strong consensus that diversification destroyed value and diversified firms suffered from a ‘diversification discount’ (Lang and Stultz 1994, Berger and Ofek 1995, Servaes 1996). However, later studies questioned the data and methodology used in these studies (Villalonga 2004a, Campa and Kedia 2002, Martin and Sayrak, 2003). Villalonga used two different databases and showed that studies based on one of them showed evidence of a diversification discount, while research on the other supported the hypothesis of a diversification premium. Her explanation of the result was that the former database showed unrelated (conglomerate) diversification while the latter showed related diversification. These new studies claimed that diversification discount was non-existent and there was actually a premium to diversification, implying that under certain circumstances, diversification creates …show more content…

if diversification is beneficial (detrimental) to the firm, it should result in higher (lower) productivity for diversified firms. Lichtenburg however used the US Census Bureau’s data on manufacturing plant-wise data and showed that diversification impacts firm productivity negatively. On the other hand, Schoar (2002) used a similar, but larger data set from the US Census Bureau’s Longitudinal Research Database and found a positive correlation between diversification and productivity of the firm. Chang et al. (2011) state that a possible explanation for this difference in opinion could be the lack of differentiation between related and unrelated diversification. They use this concept to build upon a paper to relate productivity and diversification, while keeping the distinction between related and unrelated diversification clear. They use the Data Envelopment Analysis (DEA) method to measure a firm’s relative productivity and the Entropy Measure and its decomposed components as proxies for total, related and unrelated diversification. They conclude, based on their research of data on firms of all sectors, that related (unrelated) diversification contribute to the increase (decrease) of

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