Corporate diversification and firm performance: an empirical investigation of causality

Abstract

PurposeThe purpose of this paper is to investigate the causal relationship between extent of diversification and performance among Indian companies. The key issue is to find out whether diversification provides irresistible opportunities to increase firm performance or is it the superior profitability that motivates management to diversify.Design/methodology/approachProduct diversification is calculated by using Entropy index measure. To measure joint endogeneity of corporate diversification and firm performance, both variables are treated as endogenous in a simultaneous equation model.FindingsThe results report that the association between diversification and performance turn strongly significant and positive after controlling the issue of endogeneity. The study finds a strong two-way relationship between extent of diversification and firm performance. As indicated by the results, the extent of diversification is positively related to performance, thereby implying that diversified firms experience a significant diversification premium. The study also demonstrates a positive relation of performance and total diversification indicating that good performance leads to greater diversification.Research limitations/implicationsCertain variables such as R&D intensity, export intensity and risk could not be included in the analysis for want of data. Inclusion of these independent variables could have strengthened the model and its implications.Practical implicationsThe results strongly implicate/recommend the managers of developing countries to adopt the strategy of diversification to overcome institutional inefficiencies prevailing in their domicile environment. Corporate heads must also capture the correct timings/dynamism in environment before pursuing diversification as a strategy of growth. There exists causality between diversification and performance; hence, profitable firms should capitalize synergetic effects of diversification strategy and use it as a medium of growth.Originality/valueThere was hardly any literature available on causal relationship between diversification and performance with respect to emerging countries. There was even a wider gap specifically in relation to India where none of the researchers has so far studied causality between diversification and performance controlling endogeneity.