DP3546 The Performance of Optimally Diversified Firms: Reconciling Theory and Evidence

Author(s): Joao F Gomes , Dmitry Livdan

Publication Date: September 2002

Keyword(s): firm diversification , Tobin's Q , Diversification Discount , Total Factor Productivity

JEL(s): D21 , G32 , G34

Programme Areas: Financial Economics , Industrial Organization

Link to this Page: www.cepr.org/pubs/dps/DP3546.asp

We construct an equilibrium model of firm diversification to show that the main empirical findings about firm diversification and performance are consistent with the maximization of shareholder value. In our model, diversification allows a firm to explore better productive opportunities while taking advantage of synergies. By explicitly linking the diversification strategies of the firm to differences in size and productivity, our model provides a natural laboratory to quantitatively investigate several aspects of the relationship between diversification and performance. Specifically, we show that our model is able to rationalize both the evidence on the diversification discount (Lang and Stulz (1994)) and the observed relation between diversification and firm productivity (Schoar (2002)).