Capital Market Development, Integration, Legal Systems, and the Value of Corporate Diversification: A Cross-Country Analysis

Abstract

Using a database of more than 8,000 companies from 35 countries, we find that the value of corporate diversification is related to the level of capital market development, integration, and legal systems. Among high-income countries, where capital markets are well developed and integrated, we find a significant diversification discount. By contrast, for the lower income and segmented countries, we find that there is either no diversification discount or a diversification premium. For these firms, the benefits of diversification appear to offset the agency costs of diversification. We also find that a country's legal system and the firm's ownership structure affects the value of corporate diversification among the various countries. In particular, we find that diversification discounts are largest among countries where the legal system is of English origin. We find smaller diversification discounts in countries where the legal system is of German, Scandinavian, or French origin. One interpretation of these results is that internal capital markets generated through corporate diversification are more valuable (or less costly) in countries where there is less shareholder protection and where firms find it more difficult to raise external capital. More generally, our results suggest that the financial, legal, and regulatory environment all have an important influence on the value of diversification, and that the optimal organizational structure and corporate governance may be very different for firms operating in emerging markets than it is for firms operating in more developed and integrated countries.