The Diversification Discount
Using a strategic perspective of firm growth and following the product life cycle theory, diversification spurs the growth of a firm. The Boston Consulting Group (BCG) matrix method illustrates the importance of the creation of this internal capital market to nurture the fast-growing divisions as opposed to seeking capital through the external capital market. Under the BCG-type logic, firms are encouraged to take a diversification strategy at a certain point of time within a firm's growth stages: The firm constructs a portfolio of businesses that combines both high-growth, cash-needy business units and low-growth, cash-rich units.
Does the internal capital market exist? Before discussing the efficiency of the internal capital market, there is a need to establish that the headquarters of a diversified firm is involved with the active reallocation of resources across divisions. Investigating the reliance of divisional investment on other divisions’ cash flows, Shin and Stultz (1998) find that the amount of cash flows that are available in other divisions greatly affects a division's investment. As a result, investment by divisions of diversified firms is less sensitive to their own cash flows than investment of comparable single-segment firms. Similarly, Lamont (1997) examines diversified firms operating in the oil industry and finds interdependence between one division's investment ...