Overstatement of firm diversification effect on bankruptcy risk reduction

Abstract

This paper investigates the causal relationship between firm diversification and bankruptcy risk. Specifically, we examine the causal effect of diversification on the bankruptcy risk for US public firms using the Bayesian g-formula. We confirm the presence of a causal relationship between firm diversification and bankruptcy risk and discover results for US-based firms that are consistent with coinsurance theory; namely, diversification strategy reduces bankruptcy risk. However, the causal relationship is weaker than implied by most previous correlation literature, suggesting that the value of firm diversification has been overstated in related research and that causal techniques are useful in teasing out the true magnitude of an effect.