Corporate Diversification and the Cost of Capital

Abstract

We examine whether organizational form matters for a firm's cost of capital. Contrary to the 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 stand-alone 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.