Review of Quantitative Finance and Accounting, 25: 277–291, 2005
2005 Springer Science + Business Media, Inc. Manufactured in The Netherlands.
Debt, Diversiﬁcation, and Valuation
Zicklin School of Business, Baruch College, The City University of New York, Tel: (646) 312-3188
Abstract. The separate associations between ﬁnancial leverage and valuation and between diversiﬁcation and
valuation have been widely researched. The joint function of leverage, diversiﬁcation, and valuation, however, has
received much less attention. Previous research shows that compared to specialized ﬁrms, diversiﬁed ﬁrms tend to
have higher free cash ﬂows and fewer high net present value investment opportunities. Consequently, the agency
costs associated with potential overinvestment are greater for diversiﬁed ﬁrms. The literature also proposes that
ﬁnancial leverage should reduce agency costs. Consequently, we expect that the values of diversiﬁed ﬁrms increase
with leverage. Our tests provide strong support for the hypothesis that the values of diversiﬁed ﬁrms increase with
leverage. This tendency is not observed for specialized ﬁrms.
Keywords: debt, leverage, diversiﬁcation, valuation
There has been much work on the diversiﬁcation discount and why it exists. Very little
attention, however, has been directed toward why ﬁnancial leverage might impact upon this
discount. In fact, one might expect that leverage will be more useful to the diversiﬁed (multi-
business segment) ﬁrm than to the specialized ﬁrm because diversiﬁed ﬁrms are more apt
to experience the agency costs associated with large free cash ﬂows. Jensen (1986) shows
that leverage may be used to reduce free cash ﬂows and the agency costs associated with
potential over-investment. We hypothesize that for diversiﬁed companies, the diversiﬁcation
discount is inversely related to leverage. We do not expect the same relationship to hold for
In this paper, using a sample of ﬁrms from Compustat,weﬁnd that the diversiﬁcation
discount is inversely related to leverage. The favorable effect of leverage, however, applies
only to diversiﬁed ﬁrms. These results are robust to alternative speciﬁcations of leverage
and alternative speciﬁcations of our model. We also ﬁnd that the association of leverage
and valuation is particularly strong for diversiﬁed ﬁrms that are smaller in size.
Section 2 presents the research hypothesis. In Section 3 we discuss the research design.
We describe the data sources and sample selection in Section 4. Sections 5 and 6 present
the empirical results and conclusions.