Corporate Diversification and The Cost of Capital

THE JOURNAL OF FINANCE
VOL. LXVIII, NO. 5
OCTOBER 2013
Corporate Diversication and the Cost of Capital
REBECCA N. HANN, MARIA OGNEVA, and OGUZHAN OZBAS
ABSTRACT
We examine whether organizational form matters for a rms cost of capital. Con-
trary to the conventional view, we argue that coinsurance among a rms business
units can reduce systematic risk through the avoidance of countercyclical deadweight
costs. We nd that diversied rms have, on average, a lower cost of capital than
comparable portfolios of stand-alone rms. In addition, diversied rms with less
correlated segment cash ows have a lower cost of capital, consistent with a coinsur-
ance effect. Holding cash ows constant, our estimates imply an average value gain of
approximately 5% when moving from the highest to the lowest cash ow correlation
quintile.
The conventional view among practitioners and researchers is that organi-
zational form does not matter for a rms cost of capital because, while the
imperfect correlation of business unit cash ows may help reduce idiosyncratic
risk, this should have no effect on systematic risk. Long a part of mainstream
thought, the conventional view is widely disseminated through standard -
nance textbooks and classroom teaching. The notion that corporate diversica-
tion cannot affect systematic risk is usually covered explicitly in the mergers
and acquisitions chapter
1
or implicitly through the stand-alone principle in the
capital budgeting chapter.
Rebecca N. Hann is with University of Maryland Smith School of Business; Maria Ogneva
and Oguzhan Ozbas are with University of Southern California Marshall School of Business. We
thank an anonymous referee, an anonymous Associate Editor, Phil Berger, Harry DeAngelo, Paul
Fischer, Ilan Guedj, Cam Harvey (the Editor), Jerry Hoberg, Chris Jones, Simi Kedia, John Mat-
susaka, Berk Sensoy, and seminar participants at Baruch College, Chinese University of Hong
Kong, Columbia University, Hong Kong University of Science and Technology, London Business
School, Northwestern University, Penn State University, Purdue University, Sabanc University,
University of Chicago, University of Hong Kong, University of New South Wales, University of
Oregon, University of Southern California, 2011 AFA Meetings, DC Area Accounting Symposium,
21
st
Annual Conference on Financial Economics and Accounting, 2010 Harvard University In-
formation, Markets, and Organizations Conference, 2010 Koc Finance Conference, 2010 Napa
Conference on Financial Markets Research, 2009 University of Minnesota Empirical Conference,
and 2010 University of Toronto Accounting Research Conference for helpful comments. We thank
Jieying Zhang for helping us with bond pricing data. We also thank the Rock Center for Corporate
Governance at Stanford University for providing access to the DealScan database and Yifeng Zhou
for his excellent research assistance. Financial support from the Marshall General Research Fund
and KPMG is gratefully acknowledged.
1
Systematic variability cannot be eliminated by diversication, so mergers will not eliminate
this risk at all. (Ross, Westereld, and Jaffe (2008, p. 823)).
DOI: 10.1111/jo.12067
1961
1962 The Journal of Finance
R
In this paper, we present evidence that is contrary to the conventional view.
We nd that diversied rms have a lower cost of capital than comparable
portfolios of stand-alone rms. We also nd that the reduction in cost of capital
is strongly related to the correlation of business unit cash ows, consistent with
a coinsurance effect.
We argue that organizational form can affect a rms cost of capital, and
in particular, coinsurancethe imperfect correlation of cash owsamong a
rms business units can reduce systematic risk through the avoidance of coun-
tercyclical deadweight costs. Using deadweight costs of nancial distress as an
illustrative example, if coinsurance reduces default risk (Lewellen (1971)) and
enables a diversied rm to avoid countercyclical deadweight costs of nan-
cial distress (Elton et al. (2001) and Almeida and Philippon (2007)) that its
business units would have otherwise incurred as stand-alone rms, then coin-
surance should lead to a reduction in the diversied rms systematic risk and
hence its cost of capital.
Costly nancial distress is, of course, just one example of deadweight costs
faced by rms. Other examples include adverse selection and transaction costs
of external nance and resulting investment distortions, forgone business op-
portunities due to defections by important stakeholders such as suppliers, cus-
tomers, or employees, and so on. Many of these costs tend to arise following low
cash ow realizationsmaking them countercyclical since low cash ow real-
izations are more likely during bad economic times. Amplication mechanisms
such as the credit channel or asset re sales can also add to the countercyclical
nature of these costs.
Our general argument is that coinsurance should enable a diversied rm
to transfer resources from cash-rich units to cash-poor units in some states of
nature and thereby avoid some of the countercyclical deadweight costs that
stand-alone rms cannot avoid on their own. As a result, cash ows of di-
versied rms should contain less systematic risk than those of comparable
portfolios of stand-alone rms. In addition, the reduction in systematic risk
should depend on the extent of coinsurance among diversied rms business
units.
We test these predictions using a sample of single- and multi-segment rms
spanning the period 19882006. Our main cost of capital proxy is the weighted
average of cost of equity and cost of debt. We use ex ante measures of expected
returns for both components of nancing: implied cost of equity constructed
from analyst forecasts to proxy for expected equity returns and yields from
the Barclays Capital Aggregate Bond Index to proxy for expected debt returns.
We estimate implied cost of equity based on the approach of Gebhardt, Lee,
and Swaminathan (2001), which has been recently employed in several asset
pricing contexts (P astor, Sinha, and Swaminathan (2008) and Lee, Ng, and
Swaminathan (2009)).
We also use two alternative proxies for expected returns: ex post realized
returns and a hybrid proxy combining ex ante and ex post approaches (tted
values from regressing ex post realized returns on a set of ex ante measures
of expected returns, which we refer to as instrumented returns). The hybrid
Corporate Diversication and the Cost of Capital 1963
approach lters out information shocks that contaminate realized returns and
make them noisy proxies for expected returns (Elton (1999)). Our empirical
analyses are based on excess cost of capital measures that benchmark the
cost of capital of a diversied rm against that of a comparable portfolio of
stand-alone rms.
Most of our ndings, which we summarize below, are robustly signicant
at conventional levels using ex ante measures of expected returns and instru-
mented returns but not realized returns. Our interpretation is that the added
level of noise in realized returns due to information shocks indeed makes real-
ized returns poor proxies for expected returns.
Using ex ante measures of expected returns as well as instrumented returns,
we nd that diversied rms, on average, have a signicantly lower cost of cap-
ital than comparable portfolios of stand-alone rms, rejecting the conventional
view that organizational form does not matter for a rms cost of capital. We
consider cash ow and investment correlations among a rms segments as an
inverse measure of coinsurance. Consistent with a coinsurance effect, we nd
a signicant positive relation between excess cost of capital and cross-segment
correlations. In addition, we examine whether coinsurance effects are stronger
for rms facing greater nancial constraints since such rms are more likely to
incur greater deadweight costs and thus benet more from coinsurance. Using
proxies of nancial constraints such as the WhitedWu index, the Hadlock
Pierce index, and S&P debt rating (speculative versus investment grade), we
nd that coinsurance effects are, in general, stronger for more nancially con-
strained rms.
These ndings are robust to controlling for potential analyst forecast biases
and using alternative measures of (i) implied cost of equity (Claus and Thomas
(2001) and Easton (2004)), (ii) cost of equity not reliant on analyst forecasts,
(iii) cost of debt inferred from publicly traded bonds or private loans, and
(iv) coinsurance. They are also robust to controlling for selection effects in
a Heckman two-stage analysis and using changes in coinsurance over which
managers arguably have no control (Lamont and Polk (2002)).
Our ndings are also economically signicant. Our estimates imply an av-
erage percentage reduction of approximately 2%3% in cost of capital and an
average value gain of approximately 5%6% when moving from the highest to
the lowest cash ow correlation quintile.
The rest of the paper proceeds as follows. Section I provides a discussion
of the setting and related research. Section II outlines the valuation approach
that we use in estimating the implied cost of equity along with the construction
of excess cost of capital and coinsurance measures. Section III describes our
sample. Section IV presents our ndings. Section V concludes.
I. The Setting
A. Systematic Risk and Cost of Capital in a Model of Coinsurance
Our hypotheses about organizational form and cost of capital are based on a
model of coinsurance in the spirit of Lewellen (1971). This section summarizes
R
the models basics and outlines the assumptions under which the imperfect
correlation of business unit cash ows lowers a diversied rms cost of capital
relative to a comparable portfolio of stand-alone rms.
2
To illustrate our main ideas, suppose that rms incur certain deadweight
losses when their projects experience low cash ow outcomes. Examples of
deadweight losses include forgone business opportunities due to defections by
important stakeholders such as suppliers, customers, or employees, nancial
distress or external nance costs, and so on. A large body of research in nance
shows that the expected value of such deadweight losses is higher during worse
economic times, possibly due to the higher incidence of low cash ow outcomes,
or due to amplication mechanisms such as the credit channel or asset re
sales. As a result, rms face deadweight losses that are partly countercyclical
and rms cash ows contain more systematic risk than they otherwise would
in a frictionless world. That is, countercyclical deadweight losses add to the
systematic risk of rms.
In such a setting, it is straightforward to show that a diversied rms sys-
tematic risk would be lower than that of a comparable portfolio of stand-alone
rms. The imperfect correlation of business unit cash ows allows resources
to be transferred from cash-rich units to cash-poor units in some states of na-
ture to avoid some of the countercyclical deadweight losses that stand-alone
rms cannot avoid on their own. More generally, a diversied rm with less
correlated business unit cash ows, and hence greater coinsurance potential
would have less systematic risk. Only in the case of perfectly correlated busi-
ness unit cash ows would a diversied rms systematic risk approach that of
a comparable portfolio of stand-alone rms.
For these results to hold, two further assumptions are needed. First, it must
be costly for stand-alone rms to enter into state-contingent nancing contracts
with each other to replicate the extent of deadweight loss avoidance achieved by
diversied rms. Second, it must be costly for rms to hold rst-best amounts
of nancial slack to avoid all future deadweight losses. Both assumptions strike
us as accurate descriptions of the real world. Veriability and enforcement fric-
tions likely render state-contingent nancing contracts expensive or infeasible.
In addition, tax and agency costs likely discourage rms from holding rst-best
amounts of nancial slack.
In the Internet Appendix, we consider two extensions of the basic model.
3
First, we allow for the possibility of agency costs of diversication and the
possibility of inefcient internal capital markets to address a model prediction
that some might see as counterfactualthe basic model without any cost of
diversication predicts a diversication premium. We show that these costs
do not change the qualitative implications of the model about countercyclical
coinsurance. So, it is possible to observe both a diversication discount and a
2
We use the model to derive additional testable predictions, which we later state in this section.
The formal analysis can be found in the Internet Appendix.
3
The Internet Appendix may be found in the online version of this article.
coinsurance effect at the same time. Second, we extend the model to include
debt alongside equity and show that the coinsurance results apply to both debt
and equity nancing.
To summarize, the model setting outlined above has the following testable
predictions. First, diversied rms should have a lower cost of capital than com-
parable portfolios of stand-alone rms. Second, the reduction in cost of capital
should be related to expected coinsurance opportunities. Diversied rms with
less correlated business unit cash ows and thus greater coinsurance potential
should have a lower cost of capital.
4
Third, diversied rms facing greater -
nancial constraints and associated deadweight losses should benet more from
coinsurance. Consequently, coinsurance effects should be more pronounced for
such rms.
B. Related Literature
The notion of coinsurance among a rms business units goes at least as far
back as Lewellen (1971). The ensuing stream of research studies coinsurance
in the context of conglomerate mergers (Higgins and Schall (1975) and Scott
(1977)) and examines whether such mergers lead to wealth transfers from
shareholders to bondholders (Kim and McConnell (1977)). Importantly, this
literature does not recognize the possibility that coinsurance can affect a rms
systematic risk. For example, standard textbooks emphasize the irrelevance
of corporate diversication and coinsurance when explaining the stand-alone
principle of capital budgeting by either implicitly following or explicitly citing
Schalls (1972) analysis. To our knowledge, our study is the rst to establish a
link between coinsurance and cost of capital.
Our study also complements the literature on corporate diversication and
rm value (Lang and Stulz (1994), Berger and Ofek (1995), Campa and
Kedia (2002), Graham, Lemmon, and Wolf (2002), Mansi and Reeb (2002), and
Villalonga (2004)) by exploring an important dimension that thus far has re-
ceived little attention, namely, cost of capital. The discussion in this literature
revolves mostly around future cash ow differences between conglomerates
and stand-alone rms, and confounding selection effects. An exception is Lam-
ont and Polk (2001), who raise the possibility that valuation differences may
arise due to differences in expected returns. They nd a signicant and neg-
ative relation between excess values and future returns for diversied rms,
suggesting that valuation differences are explained in part by differences in
expected returns. While their study introduces the important role of expected
returns in understanding the valuation of diversied rms, their main focus is
to explain the cross-sectional variation in excess value, and not how diversi-
cation affects a rms cost of capital. Our work deepens the foundations of this
4
It is worth noting that a model of contagion would generate the opposite predictions. For
instance, if the liquidity concerns of cash-poor units spread to other units of the rm and cause
deadweight losses that stand-alone rms would not incur on their own, then diversied rms would
incur greater deadweight losses than comparable portfolios of stand-alone rms.
R
literature by exploring whether the cross-sectional variation in cost of capital
is due to coinsurance.
Our work is also related to an extensive literature on the deadweight costs of
external nance, and the ability of different organizational forms to avoid them.
Livdan, Sapriza, and Zhang (2009) show that more nancially constrained
rms are riskier and earn higher expected stock returns than less nancially
constrained rms. Dimitrov and Tice (2006) show that during recessions both
sales and inventory growth rates drop more for bank-dependent stand-alone
rms than they do for rival segments of bank-dependent diversied rms. Yan,
Yang, and Jiao (2010) show that stand-alone rms experience investment de-
clines relative to diversied rms during periods of depressed conditions in ex-
ternal capital markets. Related work by Yan (2006) also shows that diversied
rms have higher valuations when external capital is more costly. Hovakimian
(2011) shows that more nancially constrained diversied rms allocate cap-
ital more efciently during recessions. Using the 20072009 nancial crisis
as a natural experiment, Kuppuswamy and Villalonga (2010) show that the
value of diversied rms increased relative to stand-alone rms due to nanc-
ing and investment advantages. Studying deadweight costs of asset re sales,
Pulvino (1998) nds that nancially constrained airlines receive lower prices
than their unconstrained rivals when selling used narrow-body aircraft. Con-
sistent with deadweight costs of asset re sales being countercyclical, Ortiz-
Molina and Phillips (2009) nd that rms with more liquid real assets have a
lower cost of capital. Finally, Duchin (2010) studies the relation between coin-
surance and rms cash retention policies. Our paper combines with Duchins
to form a nascent literature examining the implications of coinsurance for cor-
porate nance in general.
II. Empirical Design
The coinsurance hypothesis outlined in Section I.Arelates a diversied rms
cost of capital to the extent of coinsurance among its business units. In this
section, we discuss our main proxies for these constructs.
A. Cost of Capital
Prior research in nance has generally used ex post realized returns to proxy
for expected returns and cost of capital (Fama and French (1997), Lamont
and Polk (2001)). However, realized returns are noisy proxies for expected
returns due to contamination by information shocks, which can lead to biased
inferences in nite samples (Elton (1999)). To address this concern, recent
literature in accounting and nance has developed an ex ante approach to
measuring expected returns by estimating the implied cost of equity (Claus
and Thomas (2001), Gebhardt, Lee, and Swaminathan (2001), Easton (2004)).
The implied cost of equity is the internal rate of return that equates the current
stock price to the present value of all expected future cash ows to equity. Thus,
the value of the rm at time t can be expressed as
P
t
=
i=1
E
t
[FCFE
t+i
]
(1 +r
e
)
i
, (1)
where P
t
is the market value of equity at time t, FCFE
t+i
is free cash ow to
equity at time t+i, and r
e
is the implied cost of equity.
In constructing our primary measure of cost of capital, we follow the ex
ante approach of Gebhardt, Lee, and Swaminathan (2001) (hereafter, GLS) to
estimate the implied cost of equity. The GLS measure has been successfully
employed in several asset-pricing contexts (P astor, Sinha, and Swaminathan
(2008), Lee, Ng, and Swaminathan (2009), Chava and Purnanandam (2010)).
The GLS measure uses I/B/E/S consensus analyst forecasts to proxy for future
earnings (see Appendix A for details).
The total cost of capital is computed as follows:
COC
i,t
= D
i,t1
Y
BC
t
+(1 D
i,t1
)COEC
i,t
, (2)
where COC
i,t
is cost of capital for rm i in year t, Y
t
BC
is the aggregate bond
yield from the Barclays Capital Aggregate Bond Index (formerly, the Lehman
Brothers Aggregate Bond Index), COEC
i,t
is the implied cost of equity (GLS),
and D
i,t-1
is the rms book value of debt divided by total value (book value of
debt plus market value of common equity).
5
To benchmark our results against those from prior research, we also report
results based on ex post realized stock returns. In particular, we follow an
approach similar to Lamont and Polk (2001) and dene total cost of capital
as the weighted average of a rms realized equity return and the return on
the Barclays Capital Aggregate Bond Index. Realized equity returns are buy-
and-hold returns accumulated over 12 months starting in July of year t+1
(see Figure 1 for timing convention). To mitigate concerns about the noisy
nature of realized returns due to information shocks, we construct a third
measure of cost of capital that combines information from ex post and ex ante
approaches. Specically, we regress ex post realized returns on a set of ex
ante measures of cost of capital and use the tted value from the regression
as the proxy for expected returns. We include six ex ante measures of cost
of capital in the rst stage regression: 1) GLS, 2) an alternative implied cost
of capital measure based on Claus and Thomas (2001) (hereafter, CT), 3) an
alternative implied cost of capital measure based on Easton (2004) (hereafter,
PEG), 4) expected returns fromthe FamaFrench three-factor model (hereafter,
FF),
6
5) the earnings yield (E/P), and 6) the earnings yield adjusted for growth
5
Book value of debt is long-term debt (Compustat Item #9) plus short-term debt (Compustat
Item #34); market value of equity is scal year-end stock price (Compustat Item #199) multiplied
by shares outstanding (Compustat Item #25).
6
To calculate FF expected returns, we estimate factor loadings using 24 months of prior excess
returns, multiply the loadings with corresponding historical risk premiums, and add the yield on
the 10-year Treasury note. We exclude observations with negative FF cost of equity estimates from
the analysis (about 8% of our sample).
R
E
n
d

o
f

D
e
c
e
m
b
e
r
t
E
n
d

o
f

J
u
n
e
t
+
1
B
e
g
i
n
n
i
n
g
o
f

J
a
n
u
a
r
y
t
-
1
0
O
n
e
-

a
n
d

t
w
o
-
y
e
a
r
-
a
h
e
a
d
e
a
r
n
i
n
g
s

f
o
r
e
c
a
s
t
s
S
t
o
c
k

p
r
i
c
e

f
o
r

i
m
p
l
i
e
d

c
o
s
t

o
f

e
q
u
i
t
y

e
s
t
i
m
a
t
i
o
n

E
a
r
n
i
n
g
s

l
o
n
g
-
t
e
r
m

g
r
o
w
t
h

f
o
r
e
c
a
s
t

F
o
r
e
c
a
s
t

d
i
s
p
e
r
s
i
o
n

E
x
p
e
c
t
e
d

f
o
r
e
c
a
s
t

e
r
r
o
r

f
o
r

y
e
a
r
s

t
+
1
a
n
d
t
+
2
B
o
n
d

y
i
e
l
d

B
o
o
k

v
a
l
u
e

o
f

e
q
u
i
t
y

a
n
d

d
i
v
i
d
e
n
d

p
a
y
o
u
t

r
a
t
i
o

f
o
r

i
m
p
l
i
e
d

c
o
s
t

o
f

e
q
u
i
t
y

e
s
t
i
m
a
t
i
o
n

M
a
r
k
e
t

c
a
p
i
t
a
l
i
z
a
t
i
o
n

L
e
v
e
r
a
g
e
B
o
o
k
-
t
o
-
m
a
r
k
e
t

r
a
t
i
o

E
n
d

o
f

D
e
c
e
m
b
e
r
t
+
1
E
n
d

o
f

D
e
c
e
m
b
e
r
t
+
2
U
n
e
x
p
e
c
t
e
d
f
o
r
e
c
a
s
t

e
r
r
o
r

f
o
r

y
e
a
r
t
+
1
U
n
e
x
p
e
c
t
e
d
f
o
r
e
c
a
s
t
e
r
r
o
r

f
o
r

y
e
a
r
t
+
2
C
o
i
n
s
u
r
a
n
c
e
L
a
g
g
e
d

1
2
-
m
o
n
t
h

r
e
t
u
r
n

B
e
g
i
n
n
i
n
g
o
f

J
u
n
e
t
E
n
d

o
f

D
e
c
e
m
b
e
r
t
-
1
E
n
d

o
f

M
a
y
t
+
1
R
e
a
l
i
z
e
d

1
2
-
m
o
n
t
h

r
e
t
u
r
n

E
n
d

o
f

J
u
n
e
t
+
2
F
i
g
u
r
e
1
.
T
i
m
e
l
i
n
e
o
f
v
a
r
i
a
b
l
e
m
e
a
s
u
r
e
m
e
n
t
f
o
r
a
y
e
a
r
t
o
b
s
e
r
v
a
t
i
o
n
(
a
s
s
u
m
i
n
g
D
e
c
e
m
b
e
r
s
c
a
l
y
e
a
r
e
n
d
)
.
(E/P growth-adjusted).
7
This measure of instrumented returns (hereafter,
INSTRET) is likely superior to realized returns as a proxy of expected returns if
the rst-stage regression successfully purges the information shocks in realized
returns.
To compare a diversied rms cost of capital to the cost of capital that its
business units would have as stand-alone rms, we compute a measure of
excess cost of capital. For GLS and INSTRET, excess cost of capital is the
natural logarithm of the ratio of the rms cost of capital to its imputed cost
of capital. For realized returns, excess cost of capital is simply the difference
between the rms cost of capital and its imputed cost of capital. The imputed
cost of capital of the rm is a value-weighted average of the imputed cost of
capital of its segments:
iCOC
i
=
n
k=1
iMV
ik
n
k=1
iMV
ik
iCOC
ik
, (3)
where n is the number of the rms segments, iCOC
ik
is the imputed cost of
capital of segment k, which is equal to the median cost of capital of single-
segment rms in the segments industry, and iMV
ik
is the imputed market
value of segment k, calculated as in Berger and Ofek (1995).
The procedure for estimating segments imputed market values is described
in detail in Berger and Ofek (1995). In short, the procedure consists of (1)
estimating the median ratio of enterprise value to sales for all single-segment
rms in the industry to which the segment belongs, and (2) multiplying the
segments sales by the median industry ratio. Industry denitions are based
on the narrowest SIC grouping that includes at least ve single-segment rms
with at least $20 million in sales and has a non-missing cost of capital estimate.
B. Coinsurance
Measuring the level of coinsurance among a diversied rms business units
is empirically challenging because the joint distribution of future business unit
cash ows is not observable. Moreover, using the distribution of historical busi-
ness unit cash ows is problematic because rmcomposition changes over time.
Accordingly, we construct coinsurance proxies using correlations of industry-
level cash ows based on single-segment rms.
8
We dene industries using the
7
Earnings yield is computed as the ratio of net income to beginning-of-year market value of
equity, using only observations with positive net income. Because earnings yield also contains in-
formation about growth opportunities, we include a last measure, E/P growth-adjusted, calculated
as the sum of earnings yield and growth in net income over the previous year, to incorporate the
effect of earnings growth.
8
We performrobustness tests using two alternative coinsurance measures based on rm-specic
segment cash ow and investment data. In particular, in order to provide a reasonable period for
estimating cross-segment correlations, the analysis is performed using a subset of rms whose
segment structures remain unchanged for 5 or 7 years. Results from these robustness tests are
presented in the Internet Appendix.
R
narrowest SIC grouping that includes at least ve single-segment rms with
at least $20 million in sales over the last 10 years.
9
To ensure that estimated pairwise industry correlations are not contami-
nated with systematic risk, we performthe computation in two stages. First, for
each industry in a given year, we compute idiosyncratic industry cash ows for
the prior 10 years as residuals from a regression of average industry cash ow
on average market-wide cash ow and two additional size and book-to-market
factors (Fama and French (1995)). Next, for each year in our sample, we esti-
mate pairwise industry correlations using prior 10-year idiosyncratic industry
cash ows. As coinsurance of investment opportunities can also help rms
avoid deadweight costs of external nance (Matsusaka and Nanda (2002)), we
similarly estimate pairwise industry correlations using prior 10-year idiosyn-
cratic industry investments.
10
These estimated correlations serve as inputs to
our coinsurance measures described below.
As an inverse measure of coinsurance, we compute a sales-weighted portfolio
correlation measure
it(n)
for rm i in year t with n business segments as
n
p=1
n
q=1
w
ip( j)
w
iq(k)
Corr
[t10,t1]
( j, k), (4)
where w
ip(j)
is the sales share of segment p of rm i operating in industry
j (similarly for business segment q of rm i operating in industry k), and
Corr
[t10,t1]
( j, k) is the estimated correlation of idiosyncratic industry cash
ows or investments between industries j and k over the 10-year period before
year t. We obtain similar results using an alternative coinsurance measure,
which also includes the standard deviation of industry cash ow and invest-
ment (Duchin (2010)).
Note that a single-segment rms sales-weighted cash ow or investment
correlation measure equals one by denition. This is also true for a multi-
segment rm whose segments operate in the same industry.
C. Financial Constraints
We use three measures of nancial constraints to test whether coinsurance
helps rms avoid deadweight losses associated with nancial constraints: the
WhitedWu (WW) index (Whited and Wu (2006)), the size and age (SA) index
(Hadlock and Pierce (2010)), and S&P debt rating (speculative versus invest-
ment grade). The WW index and the SA index are robustly associated with
the degree of nancial constraints in recent data samples (Hadlock and Pierce
9
We perform robustness tests using three alternative coinsurance measures based on the fol-
lowing industry denitions: Fama and French (1997) 48 industries, three-digit SIC codes, and
two-digit SIC codes. These robustness tests are presented in the Internet Appendix.
10
As is standard practice, we measure cash ow as operating income before depreciation (Com-
pustat Item#13) scaled by total assets (Compustat Item#6) and investment as capital expenditures
(Compustat Item #128) scaled by total assets (Compustat Item #6).
(2010)). The support for using debt ratings comes from Campello, Graham, and
Harvey (2010), who use CFO survey data to study the real effects of nancial
constraints during the 2008 nancial crisis. They nd that, among various
archival measures of nancial constraints, credit ratings are the most highly
correlated with their survey-based measure of nancial constraints. Further,
of all the measures examined in their study, credit ratings come closest to
replicating the patterns [they] nd for the behavior of nancially constrained
and unconstrained rms during the crisis (p. 477).
III. Sample and Data
A. Sample Selection
We obtain our sample from the intersection of the Compustat and I/B/E/S
databases for the period 19882006.
11
We construct cost of capital measures by
combining rm-level accounting information from the Compustat annual les
with analyst forecasts from I/B/E/S. The excess cost of capital measures and
the coinsurance measures require availability of segment disclosures from the
Compustat segment-level les.
Additionally, we impose the following sample restrictions. First, we follow
Berger and Ofek (1995) and require that (1) all rm-years have at least
$20 million in sales to avoid distorted valuation multiples, (2) the sum of seg-
ment sales be within 1% of the total sales of the rm to ensure the integrity
of segment data, (3) all of the rms segments for a given year have at least
ve rms in the same two-digit SIC industry with non-missing rm value to
sales ratios and GLS cost of capital estimates, and (4) all rms with at least
one segment in the nancial industry (SIC codes between 6000 and 6999) be
excluded from the sample. Second, we require the following data to estimate
the GLS cost of capital measure: (1) 1- and 2-year-ahead earnings forecasts, (2)
either a 3-year-ahead earnings forecast or the long-term growth earnings fore-
cast and a positive 2-year-ahead earnings forecast, and (3) positive book value
of equity. The initial sample with available GLS excess cost of capital estimates
consists of 38,399 rm-year observations, of which 27,765 (10,634) are single-
segment (multi-segment) rms. With additional data requirements for the con-
trol variables (discussed in the next section), the nal sample consists of 30,554
rm-year observations, of which 21,969 (8,585) observations pertain to single-
segment (multi-segment) rms. Some of the sensitivity analyses impose further
data restrictions, as discussed in the corresponding sections of the paper.
B. Control Variables
To ensure that our results on the relation between coinsurance and cost
of capital are distinct from the well-documented return patterns (Fama and
11
The start of our sample period is driven by our use of pairwise industry correlation estimates
based on prior 10-year single-segment data, which start in 1978.
R
French (1992) and Jegadeesh and Titman (1993)), we control for size, book-
to-market, and momentum as proxied by the log of market capitalization, the
book-to-market ratio, and lagged buy-and-hold returns over the past 12 months,
respectively. Including a measure of momentum also controls for sluggishness
in analyst forecasts. Recent revisions in the stock markets earnings expecta-
tions, although immediately reected in stock prices, may not be incorporated
in analyst forecasts on a timely basis, which could induce a negative correlation
between past returns and implied cost of equity estimates.
12
Recent research by Hughes, Liu, and Liu (2009) shows that, when discount
rates are stochastic, implied cost of equity estimates can deviate from expected
returns and these deviations can be related to the volatility of, as well as the
sample correlation among, expected returns and cash ows, expected growth in
cash ows, and leverage. They argue that the resulting measurement error in
implied cost of equity estimates may therefore be correlated with variables that
are traditionally not associated with systematic risk exposure, explaining the
signicant correlation between implied cost of equity and leverage, expected
earnings growth, and forecast dispersion documented in prior research (Gode
and Mohanram (2003)). Therefore, we include these variables as additional
controls to avoid spurious results. All variables are winsorized at the top and
bottom 1%.
The timeline of variable measurement is depicted in Figure 1 and the deni-
tions of control variables are summarized below (numbered items refer to the
Compustat annual database):
Log(market
capitalization)
= Natural logarithm of scal year-end stock price times shares
outstanding from Compustat (#199*#25)
Leverage = Book value of debt divided by the sum of book value of debt and market
value of equity from Compustat (#9+#34)/(#9+#34+#199*#25)
Book-to-market = Ratio of book value of equity to market value of equity from Compustat
(#60/(#199*#25))
Log(forecast
dispersion)
= Natural logarithm of the standard deviation in analysts 1-year-ahead
earnings forecasts from I/B/E/S
Long-term growth
forecast
= Consensus (median) long-term growth forecast from I/B/E/S
Lagged 12-month
return
= Buy-and-hold stock return from the beginning of June t until the end of
May of year t+1 from CRSP
IV. Empirical Results
A. Summary Statistics: Excess Cost of Capital
In Table I, we present summary statistics for three measures of excess cost
of capital (excess GLS, RET, and INSTRET in Panels A, B, and C, respectively)
12
It is possible that we are overcontrolling by including size and the book-to-market ratio in
our regressions. First, book-to-market may be associated with coinsurance-related forward-looking
betas in a conditional asset pricing model (Petkova and Zhang (2005)). Second, size may serve as
an alternative proxy for coinsurance. Larger rms are likely to have a greater number of unrelated
projects and thus experience greater coinsurance benets.
Table I
Summary Statistics: Excess Cost of Capital
This table reports summary statistics for three measures of excess cost of capital, GLS, RET, and
INSTRET in Panels A, B, and C, respectively. The statistics are computed over the period 1988
2006 for a sample of single- and multi-segment rms. GLS, RET, and INSTRET are dened in
Appendix B. For GLS and INSTRET, excess cost of capital is dened as the natural logarithm of
the ratio of a rms cost of capital to its imputed cost of capital. For RET, excess cost of capital
is the difference between a rms cost of capital and its imputed cost of capital. The imputed cost
of capital of a rm is a value-weighted average of the imputed cost of capital of its segments.
Specically,
iCOC
i
=
n
k=1
iMV
ik
n
k=1
iMV
ik
iCOC
ik
,
where n is the number of the rms segments, iCOC
ik
is the imputed cost of capital of segment
k, which is equal to the median cost of capital of single-segment rms in the segments industry,
and iMV
ik
is the imputed market value of segment k, calculated as in Berger and Ofek (1995). For
each segment, an industry is the narrowest SIC grouping that includes at least ve single-segment
rms with non-missing cost of capital estimates. ***, **, or * indicate that the coefcient estimate
is signicant at the 1%, 5%, or 10% level, respectively.
Obs. Mean Std. Dev. Lower Quartile Median Upper Quartile
Panel A. Excess GLS
Single-segment 21,969 0.038*** 0.281 0.127 0.002*** 0.093
Multi-segment 8,585 0.048*** 0.270 0.153 0.027*** 0.090
MS-SS 0.010*** 0.025***
Panel B. Excess RET
Single-segment 21,880 0.006*** 0.226 0.118 0.007*** 0.105
Multi-segment 8,544 0.005** 0.216 0.098 0.002 0.104
MS-SS 0.012*** 0.006***
Panel C. Excess INSTRET
Single-segment 12,897 0.000 0.198 0.104 0.000 0.099
Multi-segment 5,260 0.026*** 0.198 0.137 0.031*** 0.077
MS-SS 0.026*** 0.031***
for multi- and single-segment rms. Because the results for excess GLS and
INSTRET are qualitatively similar, we focus our discussion on the results
for excess GLS. For the multi-segment subsample, both mean and median
excess GLS are negative and signicant (0.048 and 0.027). For the single-
segment subsample, the median value of excess GLS is close to zero (0.002),
although the estimate is still statistically signicant.
13
The mean value of
excess GLSis negative (0.038) and signicant, indicating that the distribution
13
Note that, for single-segment rms, the median values of all excess cost of capital measures
are zero by construction because the imputed values are calculated using the cost of capital of the
median single-segment rm in each industry. The reported median values differ slightly from zero
due to the elimination of observations with missing control variables.
R
is negatively skewed. The difference in means between the multi- and single-
segment subsamples is negative (0.010) and different from zero at better
than the 1% level of statistical signicance, rejecting the conventional view
that organizational form does not matter for a rms cost of capital.
In contrast, the mean value of excess RET is positive (0.005) and signi-
cant for multi-segment rms, and negative (0.006) and signicant for single-
segment rms. The difference in means between multi- and single-segment
rms is positive (0.012) and signicant. It is worth noting that the results us-
ing excess RETare consistent with those using excess GLS and INSTRETwhen
we compare multi-segment rms with higher and lower levels of coinsurance
in the next section.
Recall that our excess GLSand INSTRETcost of capital measures are dened
as the natural logarithms of the ratio of the rms cost of capital to its imputed
cost of capital based on comparable single-segment rms. Hence, when we
discuss percentage differences in excess cost of capital, we imply logarithmic
percentage differences throughout the paper. Using the estimate for excess GLS
as an examplea logarithmic percentage difference of 1% (0.010) between
multi- and single-segment rmsthe cost of capital of a multi-segment rm
would be roughly 9.9% if the cost of capital of a single-segment rm were 10%.
The modest difference in cost of capital is likely due to the pooling of all multi-
segment rms, many of which operate within a single industry and enjoy little
cross-segment coinsurance.
B. Analysis of Excess Cost of Capital and Coinsurance
B.1. Nonparametric Results
In Table II, we sort our sample of multi-segment rms into quintiles based
on cross-segment cash ow and investment correlations (dened in Section
II.B), where the highest correlation quintile contains multi-segment rms with
correlations of one. We report the average excess GLS, RET, and INSTRET for
each quintile in panels A, B, and C, respectively.
14
We also present the results
for single-segment rms. Note that single-segment rms can be viewed as limit
observations with respect to the degree of coinsurancefor these rms, cash
ow and investment correlations equal one by denition. Because the results
are qualitatively similar across the two correlation sorts and across the three
measures of excess cost of capital, we focus our discussion on the rst sort based
on cross-segment cash ow correlations for excess GLS.
15
Consistent with the coinsurance hypothesis, we observe a monotonic in-
crease in excess GLS from the lowest correlation quintile (Q1) with the most
14
We maintain the same quintile break points across Panels A, B, and C. This stabilizes the
quintiles and makes themcomparable across the different panels, but, due to missing observations,
leads to a slightly uneven number of observations in Panels B and C.
15
While the results across the three measures of excess cost of capital are qualitatively similar
within the multi-segment sample, the difference between Q1 and single-segment rms for excess
RET is markedly weaker (0.001 for both cash ow and investment correlation sorts).
Table II
Excess Cost of Capital and Cross-Segment Correlations
This table presents excess cost of capital sorts based on cross-segment cash ow and investment
correlations. The sample period spans 19882006. Measures of excess cost of capital, GLS, RET,
and INSTRET are dened in Appendix B. Multi-segment rms are sorted into quintiles based on
their cross-segment cash ow and investment correlations, where the highest correlation quintile
contains multi-segment rms with correlations of one. Cash ow and investment correlations for
a rm are measured as the sales-weighted sum of pairwise segment correlations estimated using
idiosyncratic industry cash ow and investment based on single-segment rms over a prior 10-
year period. ***, **, or * indicate that the estimate is signicant at the 1%, 5%, or 10% level,
respectively.
Firms Sorted by
Cash Flow Correlations Investment Correlations
Obs. Sort Variable Excess COC Obs. Sort Variable Excess COC
Panel A. Excess GLS
Multi-segment Firms
Q1 (Lowest correlation) 1,495 0.414 0.059 1,495 0.430 0.072
Q2 1,496 0.734 0.054 1,496 0.760 0.056
Q3 1,496 0.911 0.050 1,496 0.929 0.042
Q4 1,496 0.998 0.046 1,496 0.999 0.039
Q5 (Highest correlation) 2,602 1.000 0.038 2,602 1.000 0.038
Single-segment rms 21,969 1.000 0.038 21,969 1.000 0.038
Q1Q5 0.022*** 0.034***
Q1Single-segment 0.022*** 0.034***
Panel B. Excess RET
Multi-segment Firms
Q1 (Lowest correlation) 1,489 0.414 0.005 1,483 0.429 0.005
Q2 1,490 0.733 0.004 1,489 0.760 0.014
Q3 1,487 0.911 0.014 1,494 0.929 0.020
Q4 1,487 0.998 0.007 1,487 0.999 0.009
Q1Q5 0.017*** 0.016**
Q1Single-segment 0.001 0.001
Panel C. Excess INSTRET
Multi-segment Firms
Q1 (Lowest correlation) 903 0.413 0.037 933 0.433 0.046
Q2 937 0.736 0.038 963 0.758 0.036
Q3 948 0.911 0.036 890 0.928 0.035
Q4 921 0.998 0.014 923 0.999 0.008
Q1Q5 0.024** 0.033**
Q1Single-segment 0.037** 0.046**
R
coinsurance to the highest correlation quintile (Q5) with the least coinsur-
ance. The mean difference between Q1 and Q5 is a statistically signicant
0.022. Similarly, the mean difference between the cost of capital of multi-
segment rms in the lowest correlation quintile (Q1) and single-segment rms
is 0.022, consistent with a signicant coinsurance effect. These results reject
the conventional view in favor of the coinsurance hypothesisdiversied rms
that consist of businesses with less correlated cash ows have a lower cost of
capital.
B.2. Main Regression Results
Next, we investigate whether the nonparametric evidence in Table II is ro-
bust to controlling for the set of rm characteristics discussed in Section III.B
The results of this analysis are presented in Table III with standard errors
block-bootstrapped by year reported in parentheses below corresponding coef-
cients.
16
Panel A of Table III reports results for the full sample. Consistent with
the nonparametric results, the coefcient estimate on cross-segment cash ow
correlations is positive for all three measures of excess cost of capital and it
is different from zero at the 1% level of statistical signicance for excess GLS
and INSTRET. Similarly, the coefcient estimate on cross-segment investment
correlations is positive and different from zero at the 1% level for excess GLS
and INSTRET and at the 10% level for excess RET.
Panel B of Table III reports regression results for the sample of multi-
segment rms. The results with excess GLS and INSTRET are similar to those
for the full sample. With excess RET, coinsurance estimates remain positive but
are no longer statistically signicant, consistent with concern in the literature
that realized returns are noisy proxies of expected returns.
Overall, our results reject the conventional view in favor of the coinsurance
hypothesis. Firms with lower cross-segment cash ow correlations and hence
greater coinsurance potential have a lower cost of capital.
B.3. Financial Constraints
As discussed in Section I.A, one would expect the benet of coinsurance and
its effect on cost of capital to be more pronounced for diversied rms facing
greater nancial constraints and associated deadweight costs. We test this pre-
diction using three measures of nancial constraints: the WW index, the SA
index, and S&P debt rating (see Section II.C).
17
The results for each measure
16
We report bootstrapped standard errors to account for the generated regressor problem due to
the inherent estimation uncertainty in our coinsurance measures. Our inferences are unchanged
using robust standard errors that are heteroskedasticity consistent and double clustered by rm
and year (Petersen (2009)).
17
The Internet Appendix contains additional results based on three other measures (net debt,
cash, and the KZ index), which Hadlock and Pierce (2010) argue rely on nancial choices made by
managers and therefore may not have a straightforward relation to nancial constraints.
Table III
Regressions of Excess Cost of Capital on Cross-Segment Correlations
This table presents regressions of excess cost of capital on cross-segment correlations. The regres-
sions are estimated over the period 19882006 for a sample of single- and multi-segment rms
(multi-segment rms) in Panel A (B). Cash ow and investment correlations for a rm are mea-
sured as the sales-weighted sum of pairwise segment correlations estimated using idiosyncratic
industry cash ow and investment based on single-segment rms over a prior 10-year period.
All other variables are dened in Appendix B. Standard errors block-bootstrapped by year are in
parentheses. ***, **, or * indicate that the coefcient estimate is signicant at the 1%, 5%, or 10%
level, respectively.
GLS RET INSTRET
Model 1 Model 2 Model 1 Model 2 Model 1 Model 2
Panel A. Full Sample
Cash ow correlations 0.068*** 0.020 0.054***
(0.012) (0.020) (0.012)
Investment correlations 0.088*** 0.036* 0.066***
(0.015) (0.022) (0.017)
Number of segments 0.008*** 0.009*** 0.006 0.007 0.007*** 0.008***
(0.003) (0.003) (0.005) (0.005) (0.002) (0.002)
Logarithm of market 0.029*** 0.029*** 0.005 0.005 0.025*** 0.025***
capitalization (0.005) (0.006) (0.005) (0.005) (0.004) (0.004)
Leverage 0.157*** 0.157*** 0.102** 0.101** 0.123*** 0.122***
(0.022) (0.022) (0.043) (0.043) (0.014) (0.014)
Book-to-market 0.120*** 0.120*** 0.025** 0.025** 0.010 0.009
(0.021) (0.021) (0.010) (0.010) (0.012) (0.012)
Lagged 12-month return 0.081*** 0.081*** 0.005 0.005 0.112*** 0.112***
(0.009) (0.009) (0.016) (0.016) (0.008) (0.008)
Long-term growth forecast 0.370*** 0.371*** 0.371*** 0.371***
(0.112) (0.113) (0.038) (0.038)
Logarithm of forecast 0.009*** 0.009*** 0.028*** 0.028***
dispersion (0.002) (0.002) (0.002) (0.002)
Constant 0.146*** 0.126*** 0.090* 0.073* 0.158*** 0.146***
(0.056) (0.049) (0.047) (0.038) (0.039) (0.033)
Observations 30,554 30,554 30,424 30,424 18,157 18,157
R
2
0.121 0.122 0.002 0.002 0.156 0.156
Panel B. Multi-segment Sample
Cash ow correlations 0.052*** 0.019 0.050***
(0.011) (0.020) (0.011)
Investment correlations 0.072*** 0.036 0.063***
(0.016) (0.022) (0.018)
Number of segments 0.017*** 0.017*** 0.010** 0.011*** 0.009*** 0.009***
(0.003) (0.003) (0.004) (0.004) (0.003) (0.003)
Logarithm of market 0.033*** 0.033*** 0.006 0.005 0.026*** 0.026***
capitalization (0.006) (0.006) (0.005) (0.005) (0.006) (0.006)
Leverage 0.191*** 0.190*** 0.064** 0.061** 0.117*** 0.116***
(0.040) (0.040) (0.029) (0.029) (0.025) (0.024)
(Continued)
R
Table IIIContinued
GLS RET INSTRET
Panel B. Multi-segment Sample
Book-to-market 0.141*** 0.140*** 0.031** 0.031** 0.015 0.014
(0.040) (0.040) (0.015) (0.015) (0.022) (0.022)
Lagged 12-month return 0.068*** 0.068*** 0.014 0.014 0.118*** 0.118***
(0.014) (0.014) (0.017) (0.017) (0.011) (0.010)
Long-term growth forecast 0.310** 0.315** 0.396*** 0.396***
(0.122) (0.124) (0.095) (0.096)
Logarithm of forecast 0.006* 0.007* 0.023*** 0.024***
dispersion (0.003) (0.004) (0.005) (0.005)
Constant 0.133* 0.116 0.069 0.053 0.141** 0.131**
(0.076) (0.071) (0.044) (0.039) (0.064) (0.059)
Observations 8,585 8,585 8,544 8,544 5,260 5,260
R
2
0.111 0.112 0.002 0.002 0.132 0.134
are, respectively, presented in Panels A, B, and Cof Table IV(nonparametric re-
sults) and Table V (regression results). Consistent with relatively weak results
using realized returns in the main analysis in Table III, we nd no signicant
interactions between nancial constraints and coinsurance for excess RET. To
streamline the presentation, and, more importantly, to underscore that excess
GLS and INSTRET are likely superior measures of cost of capital compared
to ex post realized returns, we focus on those two measures in the rest of the
analyses.
18
Table IV presents nonparametric results where we sequentially sort obser-
vations rst on each measure of nancial constraints, and then within each
nancial constraint partition, on cash ow or investment correlations.
19
For
the WW and SA index, we sort observations into high- and low-constraint sub-
samples using the median as a cutoff.
20
For S&P debt rating, the sample is
partitioned based on whether the rms credit rating is lower than BBB (Spec-
ulative Grade) or BBBand higher (Investment Grade). Similar to Table II, we
18
As pointed out by Elton (1999), ex post realized returns can be noisy proxies for ex ante
expected returns and may lead to biased coefcient estimates innite samples due to contamination
by cash ow shocks. Several recent papers (Campello, Chen, and Zhang (2008) and Chava and
Purnanandam (2010)) show that these biases can be substantial, and our analysis in the previous
section bears out a similar conclusion. For interested readers, the Internet Appendix contains
results on nancing constraints for realized returns.
19
In all three panels, the number of observations for Q5 is higher than that in Q1Q4 because
Q5 includes all multi-segment rms with cash ow and investment correlations equal to one.
20
The number of multi-segment observations is not evenly distributed across the high and
low partitions of WW and SA in Panels A and B because the sorting on nancial constraints is
performed for the full sample of multi- and single-segment rms. A robustness test that performs
the nancial constraint sort within only multi-segment rms yields qualitatively and statistically
similar results.
Table IV
Excess Cost of Capital, Cross-Segment Correlations,
and Financial Constraints
This table presents two-way sorts based on cross-segment cash ow and investment correlations
and three measures of nancial constraints, the WW index, the SA index, and S&P debt ratings,
in Panels A, B, and C, respectively. Observations are rst sorted based on the degree of nancial
constraints. Within each nancial constraint partition, observations are sorted based on cash ow
and investment correlations. The sample period spans 19882006. Measures of excess cost of
capital, GLS and INSTRET, are dened in Appendix B. Cash ow and investment correlations for
a rm are measured as the sales-weighted sum of pairwise segment correlations estimated using
idiosyncratic industry cash ow and investment based on single-segment rms over a prior 10-
year period. Observations in Panel A (B) are partitioned into above- and below-median WW (SA)
index. Observations in Panel C are partitioned into speculative grade (below BBB) or investment
grade (BBB or above) credit ratings. ***, **, or * indicate signicance at the 1%, 5%, or 10% level,
respectively.
Panel A. WW Index
Firms Sorted by
Excess GLS Obs. Low WW Obs. High WW Obs. Low WW Obs. High WW
Multi-segment Firms
Q1 (Lowest correlation) 293 0.024 674 0.072 293 0.031 674 0.087
Q2 294 0.026 674 0.064 294 0.011 674 0.079
Q3 294 0.018 674 0.075 294 0.003 674 0.055
Q4 294 0.011 674 0.045 294 0.005 674 0.035
Q5 (Highest correlation) 536 0.010 984 0.040 536 0.010 984 0.040
Single-segment rms 8,634 0.025 6,665 0.035 8,634 0.025 6,665 0.035
Q1Q5 0.014 0.033*** 0.021 0.047***
Q1Single-segment 0.001 0.037*** 0.006 0.052***
Firms Sorted by
Excess INSTRET Obs. Low WW Obs. High WW Obs. Low WW Obs. High WW
Multi-segment Firms
Q2 241 0.012 473 0.058 232 0.004 496 0.054
Q3 222 0.040 507 0.070 215 0.021 469 0.061
Q4 204 0.054 525 0.040 206 0.058 525 0.040
Single-segment Firms 5,635 0.031 5,192 0.032 5,635 0.031 5,192 0.032
Q1Q5 0.024 0.025** 0.026 0.039***
Q1Single-segment 0.020 0.024*** 0.023* 0.038***
(Continued)
present the difference between Q1 and Q5 and between Q1 and single segment
rms and examine whether coinsurance effects are more pronounced for the
subsample that faces greater nancial constraints. We nd that the Q1Q5
and Q1Single-Segment Firms differences tend to be more pronounced
R
Table IVContinued
Panel B. SA Index
Firms Sorted by
Excess GLS Obs. Low SA Obs. High SA Obs. Low SA Obs. High SA
Multi-segment Firms
Q2 598 0.048 371 0.061 598 0.053 371 0.075
Q3 598 0.034 371 0.063 598 0.033 371 0.044
Q4 598 0.031 371 0.043 598 0.023 371 0.023
Q1Q5 0.025** 0.034** 0.029*** 0.059***
Q1Single-segment 0.012 0.052*** 0.016** 0.077***
Firms Sorted by
Excess GLS Obs. Low SA Obs. High SA Obs. Low SA Obs. High SA
Multi-segment Firms
Q2 446 0.039 267 0.050 459 0.031 268 0.047
Q3 456 0.045 273 0.026 434 0.047 251 0.024
Q4 476 0.017 253 0.003 482 0.013 250 0.001
Q1Q5 0.016 0.045** 0.027** 0.050***
Q1Single-segment 0.012 0.067*** 0.024*** 0.072***
Panel C. S&P Debt Rating
Firms Sorted by
Excess GLS Obs. Inv. grade Obs. Spec. grade Obs. Inv. grade Obs. Spec. grade
Multi-segment Firms
Q2 506 0.085 296 0.039 506 0.100 296 0.042
Q3 507 0.111 296 0.051 507 0.087 296 0.034
Q4 506 0.103 296 0.016 506 0.086 296 0.012
Q1Q5 0.010 0.024 0.015 0.043***
Q1Single-segment 0.010 0.008 0.016 0.027**
(Continued)
Table IVContinued
Firms Sorted by
Excess INSTRET Obs. Inv. grade Obs. Spec. grade Obs. Inv. grade Obs. Spec. grade
Multi-segment Firms
Q2 364 0.062 124 0.021 390 0.056 122 0.043
Q3 386 0.074 121 0.061 372 0.060 117 0.031
Q4 413 0.050 137 0.015 396 0.054 138 0.010
Q1Q5 0.003 0.028 0.021* 0.041*
Q1Single-segment 0.002 0.029 0.016* 0.041**
for the high nancial constraints subsample (rms with higher WW and SA
index or with speculative grade credit rating).
Table V presents regression results for the full sample as well as for the
subsample of multi-segment rms. The main coefcient of interest is the
interaction term between cross-segment correlations and measures of nan-
cial constraints. For Panels A and B, the WW and SA index are measured as
quintile rank that ranges from zero for rms in the lowest index quintile
(least nancially constrained) to four for rms in the highest index quintile
(most nancially constrained). For Panel C, speculative grade is an indicator
variable equal to one (zero) for rms with S&P credit rating below BBB (BBB
or above). The coefcient estimates on the interaction between cross-segment
correlations and nancial constraints measures are all positive and signicant,
except for excess INSTRET in the multi-segment sample in Panel C. Overall,
these results suggest that coinsurance effects are stronger for rms facing
greater nancial constraints, consistent with the prediction that coinsurance
benets are greater for these rms.
B.4. Controlling for Selection Effects
Our estimates of the coinsurance effect might be biased due to selec-
tion effects arising from rms decisions to diversify, an issue that has been
addressed extensively in the diversication discount literature. However, it is
unclear how a strong monotonic relation between our continuous coinsurance
measures and excess cost of capital would be driven by a dichotomous selection
mechanism that pushes some business units to conglomerate. In addition, one
might think a priori that high-risk business units, which have the most to gain
from coinsurance, are more likely to diversify than low-risk business units,
in which case the selection bias would work against us nding a coinsurance
effect.
R
T
a
b
l
e
V
R
e
g
r
e
s
s
i
o
n
s
o
f
E
x
c
e
s
s
C
o
s
t
o
f
C
a
p
i
t
a
l
o
n
C
r
o
s
s
-
S
e
g
m
e
n
t
C
o
r
r
e
l
a
t
i
o
n
s
a
n
d
F
i
n
a
n
c
i
a
l
C
o
n
s
t
r
a
i
n
t
s
T
h
i
s
t
a
b
l
e
p
r
e
s
e
n
t
s
r
e
g
r
e
s
s
i
o
n
s
o
f
e
x
c
e
s
s
c
o
s
t
o
f
c
a
p
i
t
a
l
o
n
c
r
o
s
s
-
s
e
g
m
e
n
t
c
o
r
r
e
l
a
t
i
o
n
s
a
n
d
i
n
t
e
r
a
c
t
i
o
n
s
w
i
t
h
t
h
r
e
e
m
e
a
s
u
r
e
s
o
f
n
a
n
c
i
a
l
c
o
n
s
t
r
a
i
n
t
s
,
t
h
e
W
W
i
n
d
e
x
,
t
h
e
S
A
i
n
d
e
x
,
a
n
d
S
&
P
d
e
b
t
r
a
t
i
n
g
s
,
r
e
s
p
e
c
t
i
v
e
l
y
,
i
n
P
a
n
e
l
s
A
,
B
,
a
n
d
C
,
f
o
r
a
s
a
m
p
l
e
o
f
s
i
n
g
l
e
-
a
n
d
m
u
l
t
i
-
s
e
g
m
e
n
t
r
m
s
.
T
h
e
r
e
g
r
e
s
s
i
o
n
s
a
r
e
e
s
t
i
m
a
t
e
d
o
v
e
r
t
h
e
p
e
r
i
o
d
1
9
8
8
2
0
0
6
.
M
e
a
s
u
r
e
s
o
f
e
x
c
e
s
s
c
o
s
t
o
f
c
a
p
i
t
a
l
,
G
L
S
a
n
d
I
N
S
T
R
E
T
,
a
n
d
c
o
n
t
r
o
l
v
a
r
i
a
b
l
e
s
a
r
e
d
e
n
e
d
i
n
A
p
p
e
n
d
i
x
B
.
C
a
s
h
o
w
a
n
d
i
n
v
e
s
t
m
e
n
t
c
o
r
r
e
l
a
t
i
o
n
s
f
o
r
a
r
m
a
r
e
m
e
a
s
u
r
e
d
a
s
t
h
e
s
a
l
e
s
-
w
e
i
g
h
t
e
d
s
u
m
o
f
p
a
i
r
w
i
s
e
s
e
g
m
e
n
t
c
o
r
r
e
l
a
t
i
o
n
s
e
s
t
i
m
a
t
e
d
u
s
i
n
g
i
d
i
o
s
y
n
c
r
a
t
i
c
i
n
d
u
s
t
r
y
c
a
s
h
o
w
a
n
d
i
n
v
e
s
t
m
e
n
t
b
a
s
e
d
o
n
s
i
n
g
l
e
-
s
e
g
m
e
n
t
r
m
s
o
v
e
r
a
p
r
i
o
r
1
0
-
y
e
a
r
p
e
r
i
o
d
.
W
W
q
u
i
n
t
i
l
e
r
a
n
k
S
A
q
u
i
n
t
i
l
e
r
a
n
k
)
i
n
P
a
n
e
l
A
(
B
)
i
s
q
u
i
n
t
i
l
e
r
a
n
k
o
f
t
h
e
W
W
(
S
A
)
i
n
d
e
x
a
n
d
r
a
n
g
e
s
f
r
o
m
z
e
r
o
f
o
r
r
m
s
i
n
t
h
e
l
o
w
e
s
t
q
u
i
n
t
i
l
e
t
o
f
o
u
r
f
o
r
r
m
s
i
n
t
h
e
h
i
g
h
e
s
t
q
u
i
n
t
i
l
e
.
S
p
e
c
u
l
a
t
i
v
e
-
g
r
a
d
e
i
s
a
n
i
n
d
i
c
a
t
o
r
v
a
r
i
a
b
l
e
e
q
u
a
l
t
o
o
n
e
(
z
e
r
o
)
f
o
r
r
m
s
w
i
t
h
a
S
&
P
c
r
e
d
i
t
r
a
t
i
n
g
b
e
l
o
w
B
B
B
(
B
B
B
o
r
a
b
o
v
e
)
.
S
t
a
n
d
a
r
d
e
r
r
o
r
s
b
l
o
c
k
-
b
o
o
t
s
t
r
a
p
p
e
d
b
y
y
e
a
r
a
r
e
i
n
p
a
r
e
n
t
h
e
s
e
s
.
*
*
*
,
*
*
,
o
r
*
i
n
d
i
c
a
t
e
t
h
a
t
t
h
e
c
o
e
f
c
i
e
n
t
e
s
t
i
m
a
t
e
i
s
s
i
g
n
i
c
a
n
t
a
t
t
h
e
1
%
,
5
%
,
o
r
1
0
%
l
e
v
e
l
,
r
e
s
p
e
c
t
i
v
e
l
y
.
F
u
l
l
S
a
m
p
l
e
M
u
l
t
i
-
s
e
g
m
e
n
t
S
a
m
p
l
e
G
L
S
I
N
S
T
R
E
T
G
L
S
I
N
S
T
R
E
T
P
a
n
e
l
A
.
W
W
I
n
d
e
x
C
a
s
h
o
w
c
o
r
r
e
l
a
t
i
o
n
s
0
.
0
2
8
*
*
*
0
.
0
3
1
*
*
0
.
0
2
9
*
*
*
0
.
0
0
0
(
0
.
0
0
8
)
(
0
.
0
1
5
)
(
0
.
0
1
0
)
(
0
.
0
1
7
)
C
a
s
h
o
w
c
o
r
r
e
l
a
t
i
o
n
s
0
.
0
3
8
*
*
*
0
.
0
0
6
*
*
0
.
0
4
1
*
*
*
0
.
0
1
5
*
*
*
W
W
q
u
i
n
t
i
l
e
r
a
n
k
(
0
.
0
0
3
)
(
0
.
0
0
2
)
(
0
.
0
0
7
)
(
0
.
0
0
4
)
I
n
v
e
s
t
m
e
n
t
c
o
r
r
e
l
a
t
i
o
n
s
0
.
0
1
4
0
.
0
3
4
*
0
.
0
2
0
0
.
0
0
2
(
0
.
0
1
1
)
(
0
.
0
1
8
)
(
0
.
0
1
2
)
(
0
.
0
2
1
)
I
n
v
e
s
t
m
e
n
t
c
o
r
r
e
l
a
t
i
o
n
s
0
.
0
3
8
*
*
*
0
.
0
0
6
*
*
0
.
0
4
3
*
*
*
0
.
0
1
6
*
*
*
W
W
q
u
i
n
t
i
l
e
r
a
n
k
(
0
.
0
0
3
)
(
0
.
0
0
2
)
(
0
.
0
0
7
)
(
0
.
0
0
4
)
N
u
m
b
e
r
o
f
s
e
g
m
e
n
t
s
0
.
0
0
9
*
*
*
0
.
0
1
0
*
*
*
0
.
0
0
9
*
*
*
0
.
0
0
9
*
*
*
0
.
0
1
6
*
*
*
0
.
0
1
6
*
*
*
0
.
0
1
3
*
*
*
0
.
0
1
3
*
*
*
(
0
.
0
0
3
)
(
0
.
0
0
3
)
(
0
.
0
0
3
)
(
0
.
0
0
3
)
(
0
.
0
0
3
)
(
0
.
0
0
3
)
(
0
.
0
0
3
)
(
0
.
0
0
3
)
L
o
g
a
r
i
t
h
m
o
f
m
a
r
k
e
t
0
.
0
5
5
*
*
*
0
.
0
5
5
*
*
*
0
.
0
3
3
*
*
*
0
.
0
3
3
*
*
*
0
.
0
6
0
*
*
*
0
.
0
6
1
*
*
*
0
.
0
4
1
*
*
*
0
.
0
4
1
*
*
*
c
a
p
i
t
a
l
i
z
a
t
i
o
n
(
0
.
0
0
6
)
(
0
.
0
0
6
)
(
0
.
0
0
6
)
(
0
.
0
0
6
)
(
0
.
0
0
8
)
(
0
.
0
0
9
)
(
0
.
0
0
8
)
(
0
.
0
0
8
)
L
e
v
e
r
a
g
e
0
.
2
6
0
*
*
*
0
.
2
6
1
*
*
*
0
.
1
8
3
*
*
*
0
.
1
8
3
*
*
*
0
.
3
3
0
*
*
*
0
.
3
3
3
*
*
*
0
.
2
5
0
*
*
*
0
.
2
5
0
*
*
*
(
0
.
0
2
8
)
(
0
.
0
2
8
)
(
0
.
0
1
7
)
(
0
.
0
1
7
)
(
0
.
0
4
0
)
(
0
.
0
4
0
)
(
0
.
0
2
7
)
(
0
.
0
2
6
)
B
o
o
k
-
t
o
-
m
a
r
k
e
t
0
.
1
4
3
*
*
*
0
.
1
4
2
*
*
*
0
.
0
0
2
0
.
0
0
2
0
.
2
1
3
*
*
*
0
.
2
0
9
*
*
*
0
.
0
0
5
0
.
0
0
4
(
0
.
0
2
3
)
(
0
.
0
2
3
)
(
0
.
0
1
4
)
(
0
.
0
1
4
)
(
0
.
0
3
6
)
(
0
.
0
3
6
)
(
0
.
0
2
6
)
(
0
.
0
2
6
)
L
a
g
g
e
d
1
2
-
m
o
n
t
h
r
e
t
u
r
n
0
.
0
9
2
*
*
*
0
.
0
9
1
*
*
*
0
.
1
1
5
*
*
*
0
.
1
1
5
*
*
*
0
.
0
9
3
*
*
*
0
.
0
9
3
*
*
*
0
.
1
2
6
*
*
*
0
.
1
2
5
*
*
*
(
0
.
0
0
7
)
(
0
.
0
0
7
)
(
0
.
0
0
8
)
(
0
.
0
0
8
)
(
0
.
0
1
6
)
(
0
.
0
1
6
)
(
0
.
0
1
3
)
(
0
.
0
1
3
)
L
o
n
g
-
t
e
r
m
g
r
o
w
t
h
0
.
0
4
2
0
.
0
4
3
0
.
4
3
5
*
*
*
0
.
4
3
4
*
*
*
0
.
0
2
8
0
.
0
2
2
0
.
5
5
3
*
*
*
0
.
5
5
1
*
*
*
f
o
r
e
c
a
s
t
(
0
.
0
4
3
)
(
0
.
0
4
3
)
(
0
.
0
3
6
)
(
0
.
0
3
6
)
(
0
.
0
7
6
)
(
0
.
0
7
8
)
(
0
.
0
9
9
)
(
0
.
1
0
1
)
L
o
g
a
r
i
t
h
m
o
f
f
o
r
e
c
a
s
t
0
.
0
2
5
*
*
*
0
.
0
2
6
*
*
*
0
.
0
3
2
*
*
*
0
.
0
3
2
*
*
*
0
.
0
1
6
*
*
*
0
.
0
1
7
*
*
*
0
.
0
3
2
*
*
*
0
.
0
3
2
*
*
*
d
i
s
p
e
r
s
i
o
n
(
0
.
0
0
3
)
(
0
.
0
0
3
)
(
0
.
0
0
2
)
(
0
.
0
0
2
)
(
0
.
0
0
5
)
(
0
.
0
0
5
)
(
0
.
0
0
5
)
(
0
.
0
0
6
)
(
C
o
n
t
i
n
u
e
d
)
T
a
b
l
e
V
C
o
n
t
i
n
u
e
d
F
u
l
l
S
a
m
p
l
e
M
u
l
t
i
-
s
e
g
m
e
n
t
S
a
m
p
l
e
G
L
S
I
N
S
T
R
E
T
G
L
S
I
N
S
T
R
E
T
P
a
n
e
l
A
.
W
W
I
n
d
e
x
C
o
n
s
t
a
n
t
0
.
3
4
6
*
*
*
0
.
3
3
4
*
*
*
0
.
2
2
8
*
*
*
0
.
2
2
5
*
*
*
0
.
3
1
5
*
*
*
0
.
3
1
7
*
*
*
0
.
2
7
5
*
*
*
0
.
2
7
5
*
*
*
(
0
.
0
6
1
)
(
0
.
0
5
2
)
(
0
.
0
4
9
)
(
0
.
0
4
3
)
(
0
.
0
8
8
)
(
0
.
0
8
6
)
(
0
.
0
7
4
)
(
0
.
0
7
1
)
O
b
s
e
r
v
a
t
i
o
n
s
2
0
,
6
9
0
2
0
,
6
9
0
1
4
,
7
7
9
1
4
,
7
7
9
5
,
3
9
1
5
,
3
9
1
3
,
9
5
2
3
,
9
5
2
R
2
0
.
2
1
3
0
.
2
1
4
0
.
1
8
0
0
.
1
8
0
0
.
2
2
2
0
.
2
2
5
0
.
1
7
3
0
.
1
7
3
P
a
n
e
l
B
.
S
A
I
n
d
e
x
C
a
s
h
o
w
c
o
r
r
e
l
a
t
i
o
n
s
0
.
0
7
1
*
*
*
0
.
0
3
4
*
0
.
0
3
9
*
*
*
0
.
0
1
1
(
0
.
0
1
1
)
(
0
.
0
1
7
)
(
0
.
0
1
4
)
(
0
.
0
1
7
)
C
a
s
h
o
w
c
o
r
r
e
l
a
t
i
o
n
s
0
.
0
0
3
*
0
.
0
0
6
*
*
*
0
.
0
1
1
*
*
*
0
.
0
1
1
*
*
*
S
A
q
u
i
n
t
i
l
e
r
a
n
k
(
0
.
0
0
2
)
(
0
.
0
0
2
)
(
0
.
0
0
2
)
(
0
.
0
0
3
)
I
n
v
e
s
t
m
e
n
t
c
o
r
r
e
l
a
t
i
o
n
s
0
.
0
8
7
*
*
*
0
.
0
3
8
*
0
.
0
5
3
*
*
0
.
0
1
6
(
0
.
0
1
8
)
(
0
.
0
2
0
)
(
0
.
0
2
1
)
(
0
.
0
2
3
)
I
n
v
e
s
t
m
e
n
t
c
o
r
r
e
l
a
t
i
o
n
s
0
.
0
0
3
*
0
.
0
0
6
*
*
*
0
.
0
1
1
*
*
*
0
.
0
1
0
*
*
*
S
A
q
u
i
n
t
i
l
e
r
a
n
k
(
0
.
0
0
2
)
(
0
.
0
0
2
)
(
0
.
0
0
2
)
(
0
.
0
0
3
)
N
u
m
b
e
r
o
f
s
e
g
m
e
n
t
s
0
.
0
0
9
*
*
*
0
.
0
1
0
*
*
*
0
.
0
0
9
*
*
*
0
.
0
0
9
*
*
*
0
.
0
1
6
*
*
*
0
.
0
1
6
*
*
*
0
.
0
1
3
*
*
*
0
.
0
1
3
*
*
*
(
0
.
0
0
3
)
(
0
.
0
0
3
)
(
0
.
0
0
3
)
(
0
.
0
0
3
)
(
0
.
0
0
3
)
(
0
.
0
0
3
)
(
0
.
0
0
3
)
(
0
.
0
0
4
)
L
o
g
a
r
i
t
h
m
o
f
m
a
r
k
e
t
0
.
0
2
9
*
*
*
0
.
0
2
9
*
*
*
0
.
0
2
9
*
*
*
0
.
0
2
9
*
*
*
0
.
0
3
6
*
*
*
0
.
0
3
6
*
*
*
0
.
0
3
4
*
*
*
0
.
0
3
3
*
*
*
c
a
p
i
t
a
l
i
z
a
t
i
o
n
(
0
.
0
0
5
)
(
0
.
0
0
5
)
(
0
.
0
0
5
)
(
0
.
0
0
5
)
(
0
.
0
0
6
)
(
0
.
0
0
6
)
(
0
.
0
0
6
)
(
0
.
0
0
6
)
L
e
v
e
r
a
g
e
0
.
1
6
7
*
*
*
0
.
1
6
6
*
*
*
0
.
1
7
0
*
*
*
0
.
1
6
9
*
*
*
0
.
2
4
1
*
*
*
0
.
2
3
8
*
*
*
0
.
2
2
6
*
*
*
0
.
2
2
4
*
*
*
(
0
.
0
2
4
)
(
0
.
0
2
4
)
(
0
.
0
1
5
)
(
0
.
0
1
5
)
(
0
.
0
3
3
)
(
0
.
0
3
3
)
(
0
.
0
2
9
)
(
0
.
0
2
9
)
B
o
o
k
-
t
o
-
m
a
r
k
e
t
0
.
1
8
1
*
*
*
0
.
1
8
1
*
*
*
0
.
0
0
8
0
.
0
0
8
0
.
2
3
7
*
*
*
0
.
2
3
5
*
*
*
0
.
0
1
4
0
.
0
1
4
(
0
.
0
2
5
)
(
0
.
0
2
5
)
(
0
.
0
1
4
)
(
0
.
0
1
4
)
(
0
.
0
3
7
)
(
0
.
0
3
7
)
(
0
.
0
2
6
)
(
0
.
0
2
6
)
L
a
g
g
e
d
1
2
-
m
o
n
t
h
r
e
t
u
r
n
0
.
0
9
2
*
*
*
0
.
0
9
2
*
*
*
0
.
1
1
5
*
*
*
0
.
1
1
5
*
*
*
0
.
0
9
2
*
*
*
0
.
0
9
2
*
*
*
0
.
1
2
5
*
*
*
0
.
1
2
5
*
*
*
(
0
.
0
0
8
)
(
0
.
0
0
8
)
(
0
.
0
0
8
)
(
0
.
0
0
8
)
(
0
.
0
1
6
)
(
0
.
0
1
6
)
(
0
.
0
1
3
)
(
0
.
0
1
3
)
L
o
n
g
-
t
e
r
m
g
r
o
w
t
h
0
.
0
8
1
*
0
.
0
8
4
*
0
.
4
1
2
*
*
*
0
.
4
1
1
*
*
*
0
.
0
1
4
0
.
0
2
3
0
.
5
2
0
*
*
*
0
.
5
2
1
*
*
*
f
o
r
e
c
a
s
t
(
0
.
0
4
6
)
(
0
.
0
4
7
)
(
0
.
0
3
7
)
(
0
.
0
3
8
)
(
0
.
0
7
6
)
(
0
.
0
7
8
)
(
0
.
0
9
6
)
(
0
.
0
9
8
)
L
o
g
a
r
i
t
h
m
o
f
f
o
r
e
c
a
s
t
0
.
0
2
5
*
*
*
0
.
0
2
5
*
*
*
0
.
0
3
2
*
*
*
0
.
0
3
2
*
*
*
0
.
0
1
7
*
*
*
0
.
0
1
7
*
*
*
0
.
0
3
2
*
*
*
0
.
0
3
2
*
*
*
d
i
s
p
e
r
s
i
o
n
(
0
.
0
0
3
)
(
0
.
0
0
3
)
(
0
.
0
0
2
)
(
0
.
0
0
3
)
(
0
.
0
0
5
)
(
0
.
0
0
5
)
(
0
.
0
0
6
)
(
0
.
0
0
6
)
C
o
n
s
t
a
n
t
0
.
1
2
3
*
*
0
.
1
0
7
*
*
0
.
1
9
9
*
*
*
0
.
1
9
4
*
*
*
0
.
1
2
1
*
0
.
1
1
0
*
0
.
2
2
0
*
*
*
0
.
2
1
4
*
*
*
(
0
.
0
5
2
)
(
0
.
0
4
3
)
(
0
.
0
4
1
)
(
0
.
0
3
4
)
(
0
.
0
7
1
)
(
0
.
0
6
4
)
(
0
.
0
6
0
)
(
0
.
0
5
5
)
O
b
s
e
r
v
a
t
i
o
n
s
2
0
,
7
5
3
2
0
,
7
5
3
1
4
,
8
2
5
1
4
,
8
2
5
5
,
3
9
8
5
,
3
9
8
3
,
9
5
7
3
,
9
5
7
R
2
0
.
1
9
8
0
.
1
9
9
0
.
1
8
1
0
.
1
8
1
0
.
2
0
9
0
.
2
1
1
0
.
1
7
5
0
.
1
7
4
(
C
o
n
t
i
n
u
e
d
)
R
T
a
b
l
e
V
C
o
n
t
i
n
u
e
d
F
u
l
l
S
a
m
p
l
e
M
u
l
t
i
-
s
e
g
m
e
n
t
S
a
m
p
l
e
G
L
S
I
N
S
T
R
E
T
G
L
S
I
N
S
T
R
E
T
P
a
n
e
l
C
.
S
&
P
D
e
b
t
R
a
t
i
n
g
C
a
s
h
o
w
c
o
r
r
e
l
a
t
i
o
n
s
0
.
0
6
8
*
*
*
0
.
0
5
1
*
*
*
0
.
0
6
8
*
*
*
0
.
0
4
6
*
*
*
(
0
.
0
1
2
)
(
0
.
0
1
9
)
(
0
.
0
1
3
)
(
0
.
0
1
6
)
C
a
s
h
o
w
c
o
r
r
e
l
a
t
i
o
n
s
0
.
0
5
2
*
*
*
0
.
0
1
2
*
*
0
.
0
5
2
*
*
*
0
.
0
0
6
s
p
e
c
u
l
a
t
i
v
e
g
r
a
d
e
(
0
.
0
0
5
)
(
0
.
0
0
5
)
(
0
.
0
1
0
)
(
0
.
0
0
8
)
I
n
v
e
s
t
m
e
n
t
c
o
r
r
e
l
a
t
i
o
n
s
0
.
1
0
6
*
*
*
0
.
0
7
2
*
*
*
0
.
1
0
4
*
*
*
0
.
0
6
6
*
*
*
(
0
.
0
1
8
)
(
0
.
0
2
5
)
(
0
.
0
1
9
)
(
0
.
0
2
2
)
I
n
v
e
s
t
m
e
n
t
c
o
r
r
e
l
a
t
i
o
n
s
0
.
0
4
9
*
*
*
0
.
0
1
1
*
*
0
.
0
4
4
*
*
*
0
.
0
0
5
s
p
e
c
u
l
a
t
i
v
e
g
r
a
d
e
(
0
.
0
0
5
)
(
0
.
0
0
5
)
(
0
.
0
0
9
)
(
0
.
0
0
8
)
N
u
m
b
e
r
o
f
s
e
g
m
e
n
t
s
0
.
0
0
5
*
*
0
.
0
0
7
*
*
*
0
.
0
0
4
0
.
0
0
5
*
0
.
0
1
2
*
*
*
0
.
0
1
3
*
*
*
0
.
0
0
8
*
*
0
.
0
0
9
*
*
(
0
.
0
0
2
)
(
0
.
0
0
2
)
(
0
.
0
0
3
)
(
0
.
0
0
3
)
(
0
.
0
0
2
)
(
0
.
0
0
3
)
(
0
.
0
0
4
)
(
0
.
0
0
4
)
L
o
g
a
r
i
t
h
m
o
f
m
a
r
k
e
t
0
.
0
1
7
*
*
*
0
.
0
1
8
*
*
*
0
.
0
1
7
*
*
*
0
.
0
1
7
*
*
*
0
.
0
2
3
*
*
*
0
.
0
2
4
*
*
*
0
.
0
1
9
*
*
*
0
.
0
2
0
*
*
*
c
a
p
i
t
a
l
i
z
a
t
i
o
n
(
0
.
0
0
6
)
(
0
.
0
0
6
)
(
0
.
0
0
6
)
(
0
.
0
0
6
)
(
0
.
0
0
7
)
(
0
.
0
0
7
)
(
0
.
0
0
6
)
(
0
.
0
0
7
)
L
e
v
e
r
a
g
e
0
.
1
5
6
*
*
*
0
.
1
5
6
*
*
*
0
.
0
9
8
*
*
*
0
.
0
9
9
*
*
*
0
.
1
8
5
*
*
*
0
.
1
8
3
*
*
*
0
.
0
8
0
*
*
*
0
.
0
8
1
*
*
*
(
0
.
0
3
5
)
(
0
.
0
3
5
)
(
0
.
0
1
7
)
(
0
.
0
1
8
)
(
0
.
0
4
8
)
(
0
.
0
4
8
)
(
0
.
0
2
5
)
(
0
.
0
2
7
)
B
o
o
k
-
t
o
-
m
a
r
k
e
t
0
.
1
1
5
*
*
*
0
.
1
1
4
*
*
*
0
.
0
2
1
0
.
0
2
1
0
.
1
4
4
*
*
*
0
.
1
4
2
*
*
*
0
.
0
2
0
0
.
0
2
0
(
0
.
0
2
3
)
(
0
.
0
2
3
)
(
0
.
0
1
5
)
(
0
.
0
1
5
)
(
0
.
0
3
6
)
(
0
.
0
3
6
)
(
0
.
0
2
3
)
(
0
.
0
2
3
)
L
a
g
g
e
d
1
2
-
m
o
n
t
h
r
e
t
u
r
n
0
.
0
5
7
*
*
*
0
.
0
5
6
*
*
*
0
.
0
9
1
*
*
*
0
.
0
9
1
*
*
*
0
.
0
6
6
*
*
*
0
.
0
6
4
*
*
*
0
.
0
9
9
*
*
*
0
.
0
9
9
*
*
*
(
0
.
0
1
0
)
(
0
.
0
1
0
)
(
0
.
0
0
8
)
(
0
.
0
0
8
)
(
0
.
0
1
3
)
(
0
.
0
1
3
)
(
0
.
0
1
6
)
(
0
.
0
1
6
)
L
o
n
g
-
t
e
r
m
g
r
o
w
t
h
0
.
2
4
9
*
*
*
0
.
2
4
7
*
*
*
0
.
0
9
7
0
.
1
0
0
0
.
2
8
8
*
*
*
0
.
2
7
9
*
*
*
0
.
0
6
2
0
.
0
7
1
f
o
r
e
c
a
s
t
(
0
.
0
4
2
)
(
0
.
0
4
2
)
(
0
.
0
8
2
)
(
0
.
0
8
2
)
(
0
.
0
9
7
)
(
0
.
0
9
5
)
(
0
.
1
4
6
)
(
0
.
1
4
5
)
L
o
g
a
r
i
t
h
m
o
f
f
o
r
e
c
a
s
t
0
.
0
1
2
*
*
*
0
.
0
1
2
*
*
*
0
.
0
2
3
*
*
*
0
.
0
2
3
*
*
*
0
.
0
1
7
*
*
*
0
.
0
1
9
*
*
*
0
.
0
2
3
*
*
*
0
.
0
2
3
*
*
*
d
i
s
p
e
r
s
i
o
n
(
0
.
0
0
3
)
(
0
.
0
0
3
)
(
0
.
0
0
3
)
(
0
.
0
0
4
)
(
0
.
0
0
4
)
(
0
.
0
0
4
)
(
0
.
0
0
5
)
(
0
.
0
0
6
)
C
o
n
s
t
a
n
t
0
.
0
7
7
0
.
0
4
3
0
.
1
3
8
*
*
0
.
1
1
8
*
*
0
.
1
0
9
0
.
0
8
5
0
.
1
4
3
*
0
.
1
2
8
*
(
0
.
0
5
8
)
(
0
.
0
5
3
)
(
0
.
0
5
9
)
(
0
.
0
5
4
)
(
0
.
0
7
8
)
(
0
.
0
7
4
)
(
0
.
0
7
6
)
(
0
.
0
7
3
)
O
b
s
e
r
v
a
t
i
o
n
s
9
,
8
2
0
9
,
8
2
0
6
,
3
2
8
6
,
3
2
8
4
,
3
9
8
4
,
3
9
8
2
,
7
8
1
2
,
7
8
1
R
2
0
.
1
0
1
0
.
1
0
3
0
.
0
6
7
0
.
0
6
9
0
.
1
2
5
0
.
1
2
8
0
.
0
6
7
0
.
0
7
1
Nevertheless, we acknowledge that selection is an important concern and we
address this issue in two ways. First, we estimate Heckman two-stage regres-
sions to correct for potential selection biases. Second, we follow an approach
that is similar in spirit to that of Lamont and Polk (2002) and examine the
relation between exogenous changes in coinsurance and changes in excess cost
of capital. As we describe below, the results fromboth analyses suggest that our
estimates of the coinsurance effect in Table III are unlikely to be contaminated
by selection effects or rms decisions to diversify.
Heckmans Two-Stage Analysis. To control for potential selection biases using
Heckmans two-stage procedure, we rst estimate a rst-stage probit model
for rms decisions to diversify. The dependent variable in the probit model is
equal to one for a multi-segment rm and zero for a single-segment rm. We
estimate two different rst-stage models. The rst model (No Instrument)
includes all of the control variables in our main regression model. The second
model (With Instruments) further includes two instruments used in Campa
and Kedia (2002), namely, PNDIV (the fraction of all rms in the industry
that are conglomerates) and PSDIV (the fraction of sales accounted for by
conglomerates). The second-stage regressions control for the inverse Mills ratio
estimated from these two rst-stage models.
The results of the second-stage regressions for GLS and INSRET are, respec-
tively, reported in Panels A and B of Table VI. The rst two columns present
the results using the inverse Mills ratio from the No Instrument rst-stage
probit model whereas the last two columns present the results using the in-
verse Mills ratio from the With Instruments rst-stage probit model. In all
models, the estimated coefcients on cross-segment correlations are positive
and different from zero at the 1% level of statistical signicance. Importantly,
the magnitudes of the coefcients are similar to those reported in Table III.
Exogenous Changes in Coinsurance and Changes in Excess Cost of Capital.
We also follow an approach that is similar to that of Lamont and Polk (2002)
to address the issue of selection effects. Specically, we decompose changes in
cross-segment correlations into two components: an exogenous component that
reects changes in pairwise industry correlations that are arguably outside
the control of managers, and an endogenous component that reects changes
in rm segment structure that managers can control. Specically
t
= (s
t
, c
t
) (s
t1
, c
t1
)
= (s
t
, c
t
) (s
t1
, c
t
)

endogenous change in
+(s
t1
, c
t
) (s
t1
, c
t1
)

exogenous change in
, (5)
where s
t
and c
t
represent the rms segment structure and estimates of pairwise
industry correlations in year t, respectively.
Next, we regress changes in excess cost of capital on exogenous and endoge-
nous changes in cross-segment correlations as well as changes in the control
R
Table VI
Regressions of Excess Cost of Capital on Cross-Segment Correlations:
Controlling for Selection Effects
Panels A and B present second-stage excess cost of capital regressions that control for the inverse
Mills ratio from rst-stage probit models explaining whether the rm is a multi-segment rm for
GLS and INSTRET, respectively. Under No Instrument, the inverse Mills ratio is from a rst-
stage probit model with all of the control variables in the second stage. Under With Instruments,
the rst-stage probit model further includes PNDIVand PSDIV(Campa and Kedia (2002)). PNDIV
measures the fraction of all rms in the industry that are conglomerates, and PSDIV measures the
fraction of sales accounted for by conglomerates. Panels C and D present regressions of changes
in excess cost of equity capital on exogenous and endogenous changes in cash ow and investment
correlations for GLS and INSTRET, respectively. Exogenous changes reect changes solely due
to changes in pairwise industry correlations. All regressions are estimated over the period 1988
2006. Measures of excess cost of capital, GLS and INSTRET, and control variables are dened
in Appendix B. Cash ow and investment correlations for a rm are measured as the sales-
weighted sum of pairwise segment correlations estimated using idiosyncratic industry cash ow
and investment based on single-segment rms over a prior 10-year period. Standard errors block-
bootstrapped by year are in parentheses. ***, **, or * indicate that the coefcient estimate is
signicant at the 1%, 5%, or 10% level, respectively.
No Instrument With Instruments
Panel A. Heckmans Second-Stage Regression: GLS
Cash ow correlations 0.060*** 0.063***
(0.012) (0.011)
Investment correlations 0.081*** 0.084***
(0.016) (0.016)
Number of segments 0.014*** 0.014*** 0.011*** 0.012***
(0.003) (0.003) (0.004) (0.004)
Logarithm of market capitalization 0.030*** 0.030*** 0.030*** 0.030***
(0.005) (0.005) (0.005) (0.005)
Leverage 0.160*** 0.160*** 0.159*** 0.158***
(0.021) (0.021) (0.021) (0.021)
Book-to-market 0.119*** 0.118*** 0.119*** 0.119***
(0.021) (0.021) (0.021) (0.021)
Logarithm of forecast dispersion 0.009*** 0.009*** 0.009*** 0.009***
(0.002) (0.002) (0.002) (0.002)
(0.113) (0.113) (0.113) (0.113)
Lagged 12-month return 0.081*** 0.081*** 0.081*** 0.081***
(0.009) (0.009) (0.009) (0.009)
Inverse Mills ratio 0.012*** 0.011*** 0.007 0.007
(0.004) (0.004) (0.004) (0.005)
Constant 0.153*** 0.133*** 0.151*** 0.130***
(0.055) (0.048) (0.055) (0.047)
Observations 30,554 30,554 30,554 30,554
R
2
0.122 0.122 0.121 0.122
Panel B. Heckmans Second-Stage Regression: INSTRET
(0.011) (0.011)
(0.018) (0.018)
(Continued)
Table VIContinued
No Instrument With Instruments
Panel B. Heckmans Second-Stage Regression: INSTRET
Number of segments 0.010*** 0.010*** 0.012*** 0.012***
(0.002) (0.003) (0.002) (0.003)
(0.004) (0.004) (0.004) (0.004)
Leverage 0.124*** 0.123*** 0.125*** 0.125***
(0.015) (0.015) (0.015) (0.015)
Book-to-market 0.010 0.010 0.010 0.010
(0.013) (0.013) (0.013) (0.013)
(0.002) (0.002) (0.002) (0.002)
(0.044) (0.045) (0.044) (0.045)
(0.008) (0.008) (0.008) (0.008)
Inverse Mills ratio 0.005 0.004 0.010*** 0.009***
(0.004) (0.004) (0.003) (0.003)
Constant 0.157*** 0.145*** 0.161*** 0.149***
(0.039) (0.034) (0.039) (0.033)
Observations 18,157 18,157 18,157 18,157
R
2
0.151 0.152 0.152 0.152
Panel C. Changes in Excess Cost of Capital and Exogenous Changes in Cross-Segment
Correlations: GLS
Model 1 Model 2 Model 3 Model 4
Cash ow correlations 0.042
(0.030)
Cash ow correlations, exogenous 0.049**
(0.024)
Cash ow correlations, endogenous 0.029
(0.022)
Investment correlations 0.088***
(0.029)
Investment correlations, exogenous 0.080***
(0.023)
Investment correlations, endogenous 0.072***
(0.022)
Number of segments 0.011** 0.011** 0.012*** 0.012***
(0.004) (0.004) (0.004) (0.004)
(0.006) (0.006) (0.006) (0.006)
Leverage 0.286*** 0.286*** 0.285*** 0.286***
(0.020) (0.020) (0.020) (0.020)
Book-to-market 0.046*** 0.045*** 0.046*** 0.046***
(0.011) (0.011) (0.011) (0.011)
(0.002) (0.002) (0.002) (0.002)
Long-term growth forecast 0.096** 0.097** 0.096** 0.096**
(0.043) (0.043) (0.043) (0.043)
(Continued)
R
Table VIContinued
Panel C. Changes in Excess Cost of Capital and Exogenous Changes in Cross-Segment
Correlations: GLS
Model 1 Model 2 Model 3 Model 4
(0.003) (0.003) (0.003) (0.003)
Constant 0.003 0.003 0.002 0.003
(0.002) (0.002) (0.002) (0.002)
Observations 19,092 19,092 19,092 19,092
R
2
0.124 0.124 0.124 0.124
Panel D. Changes in Excess Cost of Capital and Exogenous Changes in Cross-Segment.
Correlations: INSTRET
Cash ow correlations 0.070*
(0.036)
Cash ow correlations, exogenous 0.079**
(0.032)
Cash ow correlations, endogenous 0.062**
(0.027)
Investment correlations 0.150***
(0.040)
Investment correlations, exogenous 0.117***
(0.032)
Investment correlations, endogenous 0.108***
(0.031)
Number of segments 0.007 0.007 0.008 0.008
(0.005) (0.005) (0.005) (0.005)
(0.008) (0.008) (0.008) (0.008)
Leverage 0.324*** 0.325*** 0.324*** 0.325***
(0.029) (0.029) (0.029) (0.029)
Book-to-market 0.081*** 0.082*** 0.081*** 0.082***
(0.018) (0.018) (0.018) (0.018)
(0.002) (0.002) (0.002) (0.002)
(0.066) (0.066) (0.066) (0.066)
(0.003) (0.003) (0.003) (0.003)
Constant 0.002 0.002 0.002 0.002
(0.002) (0.002) (0.002) (0.002)
Observations 10,915 10,915 10,915 10,915
R
2
0.202 0.203 0.203 0.203
variables from Table III. The results for GLS and INSTRET are, respectively,
reported in Panels C and D of Table VI. Models 1 and 3 are analogous to
Models 1 and 2 in Table III, but in a rst-differenced form, which effectively
controls for rm xed effects. Models 2 and 4 decompose total changes in cross-
segment correlations into exogenous and endogenous changes.
Similar to the regression results in Table III, the coefcient estimates on
cross-segment correlations in Models 1 and 3 are all positive and signicant in
three out of four specications. In Models 2 and 4, the coefcient estimates on
exogenous changes in cross-segment correlations are also positive and signi-
cant, with magnitudes similar to those in Table III.
It is worth noting that, while our main focus is on exogenous changes in
cross-segment correlations, endogenous changes are also of interest as a rms
cost of capital should change in response to changes in its organizational struc-
ture. Consistent with this prediction, the coefcient estimates on endogenous
changes in cross-segment correlations are all positive and signicant in three
out of four specications.
B.5. Economic Signicance
To evaluate the economic signicance of our ndings, we estimate the effect
of coinsurance-related reduction in cost of capital on rm value. In the simple
Gordon growth model, under a zero dividend growth assumption, a 1%decrease
in cost of capital from 10% to 9.9% approximately translates into a 1% increase
in rm value. However, the relation between cost of capital and rm value is,
in general, nonlinear and depends on other inputs in the valuation formula
expected earnings and earnings growth.
Our analysis compares actual rm values to as-if rm values calculated
using imputed cost of capital (i.e., the cost of capital on a comparable portfolio
of single-segment rms) while holding cash ows constant in the GLS valuation
model (described in Appendix A). The excess value attributable to differences
in cost of capital is calculated as the natural logarithm of the ratio of actual
rm value to as-if rm value.
Using this approach, we nd an economically signicant 4.8%(6.4%) average
gain in total rmvalue when moving fromthe lowest to the highest coinsurance
quintile based on cross-segment cash ow (investment) correlations. We note
that these estimates might represent a lower bound for the coinsurance effect
on rm value because our proxies are limited to segment data and do not
capture coinsurance among different product lines or geographic areas.
C. Robustness Tests
C.1. Analyst Forecast Errors
A potential limitation of implied cost of equity measures is measurement er-
rors arising from biases in analyst forecasts. We use two approaches to address
this concern. First, we control for 1- and 2-year-ahead unexpected and expected
forecast errors in our main regression models. In particular, we follow Ogneva,
Subramanyam, and Raghunandan (2007) and estimate expected forecast errors
using the prediction model in Liu and Su (2005). Our parsimonious version of
the model includes the following predictors that proxy for systematic biases in
analyst forecasts: (1) past stock returns, (2) recent analyst earnings forecast
R
revisions, and variables related to overreaction to past information, namely,
(3) forward earnings-to-price ratios, (4) long-term growth forecasts, and (5)
investments in property, plant, and equipment. Estimation of the predicted
forecast error is performed separately for 1- and 2-year-ahead forecast errors.
Unexpected forecast errors are computed as the difference between realized
errors and their predicted component. Because 1- and 2-year-ahead expected
errors are highly collinear, we use the average expected errors over the 2 years
as the control measure. The results for excess GLS and INSTRET reported
in Panel A of Table VII continue to show a positive and signicant coefcient
on cross-segment cash ow and investment correlations, suggesting that our
main ndings are unlikely driven by systematic differences in analyst forecast
biases between single- and multi-segment rms.
Second, Easton and Monahan (2005) nd that the reliability of implied cost of
equity estimates increases as analyst forecast accuracy improves. Accordingly,
we partition our sample into terciles using absolute forecast errors in 1-year-
ahead earnings and estimate cost of capital regressions within each subsample.
The results for excess GLS and INSTRET are, respectively, reported in Panels
B and C of Table VII. The coinsurance effect is weakest in the subsample
with high absolute forecast errors. These results suggest that our ndings are
unlikely driven by measurement errors in the implied cost of equity estimates
that are induced by biased forecasts. Rather, our results are weakened by
them.
C.2. Excess Cost of Debt
The model outlined in Section I.A predicts coinsurance effects for both equity
and debt. In this subsection, we investigate the effects of coinsurance on the
cost of debt. We rst construct a rm-specic measure of cost of debt using cor-
porate bond yields from Datastream and loan spreads from DealScan database
provided by Loan Pricing Corporation.
21
Specically, we use the weighted aver-
age of rm-specic bond yield spread and all-in-drawn loan spread when both
spreads are available, or the available spread when only one of the two spreads
is available.
22
Similar to excess cost of equity, excess cost of debt is estimated
as the logarithm of the ratio of the rms cost of debt to its imputed cost of debt
based on similar single-segment rms. Using this rm-specic excess cost of
debt measure, we repeat our main analysis with two additional variables to
control for variation in months to maturity and default risk (Merton (1974)).
The results are reported in Table VIII. The rst two columns report results for
excess cost of debt. The last four columns present results using excess cost of
21
We use the Compustat-DealScan link made publicly available by Michael Roberts (see Chava
and Roberts (2008)) to match the databases.
22
If a rm has more than one loan facility outstanding, we compute the rm-level all-in-drawn
spread as a weighted-average of loan facility spreads, with weights equal to the loan amounts.
Similarly, if a rm has more than one bond issue, we compute the rm-level corporate bond yield
spread as a weighted average of yield spreads, with weights equal to the bonds market values.
Table VII
Regressions of Excess Cost of Capital on Cross-Segment Correlations:
Analyst Forecast Bias
This table presents regressions of excess cost of capital on cross-segment correlations, controlling
for effects of analyst forecast biases. Panel A reports regressions with expected and unexpected
forecast errors added as controls. Panels B and C report regressions for subsamples partitioned
on the magnitude of absolute forecast error for GLS and INSTRET, respectively. The regressions
are estimated over the period 19882006. Cash ow and investment correlations for a rm are
measured as the sales-weighted sumof pairwise segment correlations estimated using idiosyncratic
industry cash ow and investment based on single-segment rms over a prior 10-year period.
The construction of expected and unexpected analyst forecast errors follows Liu and Su (2005)
and Ogneva, Subramanyam, and Raghunandan (2007). Measures of excess cost of capital, GLS
and INSTRET, and other control variables are dened in Appendix B. Standard errors block-
bootstrapped by year are in parentheses. ***, **, or * indicate that the coefcient estimate is
signicant at the 1%, 5%, or 10% level, respectively.
Panel A. Controlling for Analyst Forecast Errors
GLS INSTRET
(0.013) (0.013)
(0.017) (0.017)
Number of segments 0.009** 0.010*** 0.006** 0.006**
(0.003) (0.003) (0.003) (0.003)
(0.005) (0.005) (0.004) (0.004)
Leverage 0.172*** 0.171*** 0.136*** 0.136***
(0.024) (0.024) (0.016) (0.016)
Book-to-market 0.119*** 0.118*** 0.002 0.002
(0.019) (0.019) (0.016) (0.016)
(0.012) (0.012) (0.009) (0.009)
(0.105) (0.105) (0.055) (0.056)
Logarithm of forecast dispersion 0.005** 0.006** 0.023*** 0.023***
(0.002) (0.002) (0.002) (0.003)
Unexpected analyst forecast error in 0.135 0.133 0.102 0.102
year +1 (0.105) (0.105) (0.105) (0.105)
Unexpected analyst forecast error in 0.419*** 0.417*** 0.336*** 0.335***
year +2 (0.079) (0.079) (0.061) (0.061)
Average predicted analyst forecast 1.035*** 1.032*** 1.337*** 1.333***
error in year +1 and +2 (0.198) (0.197) (0.299) (0.297)
Constant 0.131*** 0.108*** 0.154*** 0.142***
(0.044) (0.041) (0.039) (0.035)
Observations 25,187 25,187 15,530 15,530
R
2
0.158 0.158 0.180 0.180
(Continued)
R
Table VIIContinued
Absolute Forecast Error
Low Medium High
Panel B. Partitions Based on Absolute Forecast Error: GLS
Cash ow correlations 0.106*** 0.054** 0.026**
(0.018) (0.021) (0.012)
Investment correlations 0.126*** 0.073*** 0.035**
(0.021) (0.021) (0.017)
Number of segments 0.010*** 0.011*** 0.002 0.003 0.004 0.004
(0.004) (0.004) (0.003) (0.003) (0.003) (0.003)
Logarithm of market 0.031*** 0.031*** 0.019*** 0.019*** 0.011*** 0.011***
capitalization (0.006) (0.006) (0.005) (0.005) (0.004) (0.004)
Leverage 0.082*** 0.082*** 0.173*** 0.172*** 0.213*** 0.213***
(0.031) (0.031) (0.034) (0.034) (0.022) (0.022)
Book-to-market 0.242*** 0.241*** 0.202*** 0.201*** 0.075*** 0.075***
(0.022) (0.022) (0.019) (0.019) (0.022) (0.022)
Lagged 12-month return 0.097*** 0.097*** 0.066*** 0.066*** 0.038*** 0.038***
(0.011) (0.011) (0.009) (0.009) (0.013) (0.013)
Long-term growth 0.362*** 0.363*** 0.378*** 0.380*** 0.257*** 0.258***
forecast (0.130) (0.130) (0.136) (0.137) (0.089) (0.089)
Logarithm of forecast 0.008** 0.008** 0.000 0.000 0.008* 0.008*
dispersion (0.003) (0.003) (0.003) (0.003) (0.004) (0.004)
Constant 0.031 0.012 0.043 0.025 0.088** 0.079**
(0.062) (0.053) (0.047) (0.041) (0.040) (0.038)
Observations 9,695 9,695 9,689 9,689 9,683 9,683
R
2
0.213 0.214 0.132 0.132 0.037 0.037
Panel C. Partitions Based on Absolute Forecast Error: INSTRET
Cash ow correlations 0.054*** 0.050*** 0.031
(0.020) (0.013) (0.026)
Investment correlations 0.063** 0.068*** 0.036
(0.025) (0.018) (0.031)
Number of segments 0.005* 0.006* 0.005 0.006* 0.005 0.005
(0.003) (0.003) (0.003) (0.003) (0.003) (0.003)
Logarithm of market 0.025*** 0.025*** 0.018*** 0.018*** 0.012*** 0.012***
capitalization (0.005) (0.005) (0.003) (0.003) (0.003) (0.003)
Leverage 0.041** 0.041** 0.110*** 0.110*** 0.224*** 0.223***
(0.019) (0.019) (0.020) (0.020) (0.017) (0.017)
Book-to-market 0.050*** 0.051*** 0.030** 0.030** 0.029** 0.029**
(0.019) (0.019) (0.015) (0.015) (0.011) (0.011)
(0.011) (0.011) (0.007) (0.007) (0.010) (0.010)
Long-term growth 0.159*** 0.160*** 0.371*** 0.370*** 0.691*** 0.691***
forecast (0.042) (0.042) (0.053) (0.053) (0.061) (0.062)
Logarithm of forecast 0.024*** 0.025*** 0.013*** 0.013*** 0.014*** 0.014***
dispersion (0.003) (0.003) (0.003) (0.003) (0.004) (0.004)
Constant 0.134*** 0.125*** 0.057* 0.040* 0.089* 0.085
(0.045) (0.040) (0.032) (0.023) (0.051) (0.053)
Observations 6,832 6,832 6,039 6,039 4,561 4,561
R
2
0.143 0.143 0.122 0.123 0.183 0.183
Table VIII
Regressions of Excess cost of Debt Capital on Cross-Segment
Correlations
This table presents regressions of excess cost of debt (COD) and excess cost of capital derived using
rm-specic cost of debt. The regressions are estimated over the period 19882006. Excess cost
of debt (capital) is dened as the natural logarithm of the ratio of a rms cost of debt (capital) to
its imputed cost of debt (capital) calculated using a portfolio of comparable single-segment rms.
Cost of capital is measured as the weighted average of cost of equity and cost of debt. Cost of
equity is measured as the implied cost of equity based on the approach of Gebhardt, Lee, and
Swaminathan (2001) (GLS) and instrumented equity returns (INSTRET) constructed similarly to
instrumented total returns. cost of debt is measured as the weighted average of the rm-specic
bond yield spread and all-in-drawn loan spread. Cash ow and investment correlations for a
rm are measured as the sales-weighted sum of pairwise segment correlations estimated using
idiosyncratic industry cash owand investment based on single-segment rms over a prior 10-year
period. The control variables are dened in Appendix B. Standard errors block-bootstrapped by
year are in parentheses. ***, **, or * indicate that the coefcient estimate is signicant at the 1%,
5%, or 10% level, respectively.
COD GLS INSTRET
Cash ow correlations 0.046** 0.110*** 0.051
(0.020) (0.028) (0.038)
Investment correlations 0.074*** 0.160*** 0.102**
(0.020) (0.038) (0.045)
Number of segments 0.000 0.001 0.011*** 0.012*** 0.008** 0.009***
(0.002) (0.002) (0.004) (0.004) (0.003) (0.003)
Logarithm of market 0.033*** 0.033*** 0.027*** 0.027*** 0.010** 0.010**
capitalization (0.004) (0.004) (0.005) (0.005) (0.005) (0.005)
Leverage 0.154*** 0.154*** 0.046** 0.047** 0.168*** 0.168***
(0.024) (0.024) (0.020) (0.019) (0.027) (0.027)
Book-to-market 0.033*** 0.033*** 0.123*** 0.123*** 0.067*** 0.066***
(0.012) (0.012) (0.027) (0.027) (0.024) (0.024)
(0.004) (0.004) (0.012) (0.012) (0.014) (0.014)
Long-term growth forecast 0.102** 0.102** 0.052 0.051 0.097 0.096
(0.046) (0.046) (0.071) (0.072) (0.071) (0.071)
Logarithm of forecast 0.006*** 0.006*** 0.015*** 0.015*** 0.018*** 0.018***
dispersion (0.002) (0.002) (0.003) (0.003) (0.003) (0.003)
Months to maturity 0.000*** 0.000*** 0.000 0.000 0.000 0.000
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Distance to default 0.064*** 0.064*** 0.075** 0.075** 0.070 0.073
(0.018) (0.018) (0.035) (0.035) (0.054) (0.053)
Constant 0.109*** 0.081*** 0.012 0.038 0.066 0.014
(0.030) (0.029) (0.058) (0.057) (0.079) (0.079)
Observations 4,792 4,792 4,271 4,271 2,240 2,240
R
2
0.199 0.201 0.186 0.188 0.094 0.097
capital that combines rm-specic cost of debt with the GLS implied cost of eq-
uity measure and instrumented equity return. The latter is a tted value from
realized stock returns regressed on ex ante cost of capital measures described
in Section II.A.
R
As expected, the sample size is relatively small for this analysis4,792 (4,271
and 2,240) rm-year observations for the cost of debt (GLS and INSTRET cost
of capital) analyses, compared to 30,554 rm-year observations in Table III.
For the cost of debt, the coefcient estimates on cash ow and investment
correlations are positive and signicant. For GLS, the coefcient estimates on
cash ow and investment correlations are also positive and signicant with
magnitudes about double those reported in Table III, suggesting that our main
estimates with index-level cost of debt might understate the importance of coin-
surance. For INSTRET, the coefcient is positive and signicant for investment
correlations, but it is insignicant for cash ow correlations, probably due to
the substantial drop in the number of observations. It is also worth noting that
rm-specic bond and loan yields reect both systematic and idiosyncratic risk,
so the results from the excess cost of debt analysis should be interpreted with
some caution.
V. Conclusion
In this paper, we study the connection between organizational form and cost
of capital. We argue that, with countercyclical deadweight costs, combining
business units with imperfectly correlated cash ows can lead to a reduction
in systematic risk and hence the combined rms cost of capital. This coinsur-
ance effect is decreasing in the cross-segment correlation of cash ows. Our
empirical analysis provides evidence consistent with these predictions. In par-
ticular, we nd that diversied rms have, on average, a lower cost of capital
than comparable portfolios of single-segment rms. We also nd a signicant
and positive relation between excess cost of capital and cross-segment cash
ow correlations. Holding cash ows constant, these ndings imply an eco-
nomically signicant 5%6% value gain when moving from the highest to the
lowest cash ow correlation quintile. Further, we nd that the positive rela-
tion between excess cost of capital and cross-segment cash ow correlations
is more pronounced for rms that face severe nancial constraints, consistent
with a greater coinsurance effect when expected deadweight costs of external
nancing are greater.
The core of our ndings represents a major challenge to the conventional
view that corporate diversication reduces only idiosyncratic risk. In addition,
our evidence suggesting that coinsurance affects rms cost of capital has novel
implications for valuation and capital budgeting as ignoring coinsurance effects
may yield incorrect rm value and NPV estimates, particularly in the context
of diversifying mergers and acquisitions. Moreover, because the effects that
we nd are economically signicant, coinsurance is likely to affect optimal
nancial policies. The role of coinsurance in shaping corporate nancial policies
represents an exciting avenue for future research.
Initial submission: September 18, 2009; Final version received: April 25, 2013
Editor: Campbell Harvey
Appendix A: Implied Cost of Equity Estimation
A.I. Gebhardt, Lee, and Swaminathan (2001) Measure (GLS)
The GLS measure is based on the residual income valuation model, which
is derived from the discounted dividend model with an additional assumption
of clean-surplus accounting.
23
In the model, the value of the rm at time t is
equal to
P
t
= B
t
+
i=1
E
t
[NI
t+i
r
e
B
t+i1
]
(1 +r
e
)
i
, (A1)
where P
t
is the market value of equity at time t, B
t
is the book value of equity
at time t, NI
t+i
is net income at time t+i, and r
e
is the implied cost of equity.
We assume a at term structure of interest rates.
GLS further restate the model in terms of ROE, and assume that ROE for
each rm reverts to its industry median over a specied horizon. Beyond that
horizon, the terminal value is calculated as an innite annuity of residual ROE,
P
t
= B
t
+
T
i=1
FROE
t+i
r
e
(1 +r
e
)
i
B
t+i1
+
FROE
t+T
r
e
r
e
(1 +r
e
)
T
B
t+T1
, (A2)
where B
t+i
is book value per share estimated using a clean-surplus assumption
(B
t+i
= B
t+i-1
k*FEPS
t+i
+ FEPS
t+i
, where k is the dividend payout ratio
and FEPS
t+i
is the analyst earnings per share forecast for year t+i); FROE
t+i
is future expected return on equity, which is assumed to fade linearly to the
industry median from year 3 to year T; and all other variables are as dened
previously.
As in GLS, we assume that the forecast horizon, T, is equal to 12 years.
We use median consensus forecasts to proxy for the markets future earnings
expectations and require that each observation has non-missing 1- and 2-year-
ahead consensus earnings forecasts (FEPS
t+1
and FEPS
t+2
) and positive book
value of equity. We use 3-year-ahead forecasts for future earnings per share, if
they are available in I/B/E/S; otherwise, we estimate FEPS
t+3
by applying the
long-termgrowth rate to FEPS
t+2
. We use stock price per share and forecasts of
both EPS and long-term earnings growth from the I/B/E/S summary tape as of
the third Thursday in June of each year. Book value of equity and the dividend
payout ratio for the latest scal year-end prior to each June are obtained from
the Compustat annual database.
24
We assume a constant dividend payout
ratio throughout the forecast period. For the rst 3 years, expected ROE is
23
Under the clean-surplus assumption, book value of equity at t+1 is equal to book value of
equity at t plus net income earned during t+1 minus net dividends paid during t+1.
24
Book value of equity is Compustat Item #60; the dividend payout ratio is computed as divi-
dends (Compustat Item #21) divided by earnings (Compustat Item #237). If earnings are negative,
then the dividend payout ratio is computed as dividends over 6% of total assets (Compustat Item
#6).
R
estimated as FROE
t+i
= FEPS
t+i
/B
t+i1
. Thereafter, FROE is computed by
linear interpolation to the industry median ROE (where we use Fama and
French (1997) industry denitions). The cost of equity is calculated numerically
by employing the NewtonRaphson method. We set the initial value of the
cost of equity to 9% in the rst iteration; the algorithm is considered to have
converged if the stock price obtained from the implied cost of equity deviates
from the actual stock price by no more than $0.005.
A.II. Claus and Thomas (2001) Measure (CT)
The CT expression for price per share at time t is
P
t
= B
t
+
5
i=1
FEPS
t+i
r
e
B
t+i1
(1 +r
e
)
i
+
FEPS
t+5
r
e
B
t+4
(r
e
g)(1 +r
e
)
5
, (A3)
where B
t+i
is the book value per share computed using the clean-surplus as-
sumption, FEPS
t+i
is the i-period-ahead earnings per share forecast;
25
g is the
terminal growth rate of residual earnings, which is equal to the expected in-
ation rate (nominal risk-free rate minus a real risk-free rate of 3%); and r
e
is the cost of equity capital. The implied cost of equity is estimated using the
iterative procedure described in detail above.
A.III. Easton (2004) Measure (PEG)
The model equates the price of one share to the sum of capitalized
1-year-ahead EPS and the capitalized abnormal growth in EPS. Easton
makes two simplifying assumptions, namely, zero future dividends and zero
growth in abnormal earnings changes beyond 2 years, to arrive at the PEG
model:
P
t
=
FEPS
t+2
FEPS
t+1
(r
e
)
2
, (A4)
where all variables are as previously dened. From the above model, PEG cost
of equity is calculated as a function of the forward earnings-to-price ratio and
the expected earnings growth rate:
r
e
=
g
FEPS
t+1
P
t
, (A5)
where
g =
(FEPS
t+2
FEPS
t+1
)
FEPS
t+1
. (A6)
25
We use 3-, 4-, and 5-year-ahead forecasts for future earnings per share when available in
I/B/E/S. If any of these forecasts is unavailable, we estimate the corresponding value by applying
the long-term growth rate to the 2-year-ahead forecast.
The PEG cost of equity can be estimated only for rms where 2-year-ahead
EPS forecasts exceed 1-year-ahead EPS forecasts. In addition, the estimation is
restricted to rms with forward earnings-to-price ratios greater than 0.5%. We
incorporate the predicted earnings long-termgrowth rate (ltg) in the estimation
by setting g equal to the average of 1-year-ahead earnings growth rate and ltg.
The additional winsorization procedures include restricting ltg to be less than
50%, restricting the 1-year-ahead growth rate to fall between ltg and one, and
restricting PEG cost of equity to be less than one.
Appendix B: Variable Denitions
Variable Denition
GLS The weighted average of the implied cost of equity based on the
approach of Gebhardt, Lee, and Swaminathan (2001) and the yields
from the Barclays Capital Aggregate Bond Index.
RET The weighted average of a rms realized equity return and the
return from the Barclays Capital Aggregate Bond Index.
INSTRET The tted value from regressing RET on implied cost of capital
measures constructed based on Gebhardt, Lee, and Swaminathan
(2001), Claus and Thomas (2001), and Easton (2004); expected
returns from the FamaFrench three-factor model; earnings yield;
and earnings yield adjusted for growth (see Section II.A for a more
detailed description of these measures).
Market capitalization The scal year-end stock price (#199) multiplied by shares
outstanding (#25).
Leverage The book value of debt (#9+#34) divided by the sum of book value of
debt and market capitalization.
Book-to-market The book value of equity (#60) divided by market capitalization.
Forecast dispersion The standard deviation of analysts 1-year-ahead earnings forecasts
from I/B/E/S.
Long-term growth
forecast
The median long-term growth forecast from I/B/E/S.
Lagged 12-month
return
The buy-and-hold return from the beginning of June of year t to the
end of May of year t+1.
REFERENCES
Almeida, Heitor, and Thomas Philippon, 2007, The risk-adjusted cost of nancial distress, Journal
of Finance 62, 25572586.
Berger, Philip G., and Eli Ofek, 1995, Diversications effect on rm value, Journal of Financial
Economics 37, 3965.
Campa, Jos e Manuel, and Simi Kedia, 2002, Explaining the diversication discount, Journal of
Finance 57, 17311762.
Campello, Murillo, Long Chen, and Lu Zhang, 2008, Expected returns, yield spreads, and asset
pricing tests, Review of Financial Studies 21, 12971338.
Campello, Murillo, John R. Graham, and Campbell R. Harvey, 2010, The real effects of nancial
constraints: Evidence from a nancial crisis, Journal of Financial Economics 97, 470487.
Chava, Sudheer, and Amiyatos Purnanandam, 2010, Is default risk negatively related to stock
returns? Review of Financial Studies 23, 25232559.
R
Chava, Sudheer, and Michael R. Roberts, 2008, How does nancing impact investment? The role
of debt covenants, Journal of Finance 63, 20852121.
Claus, James J., and Jacob K. Thomas, 2001, Equity risk premium as low as three percent?
Evidence from analysts earnings forecasts for domestic and international stocks, Journal of
Finance 56, 16291666.
Dimitrov, Valentin, and Sheri Tice, 2006, Corporate diversication and credit constraints: Real
effects across the business cycle, Review of Financial Studies 19, 14651498.
Duchin, Ran, 2010, Cash holdings and corporate diversication, Journal of Finance 65, 955992.
Easton, Peter D., 2004, PE ratios, PEG ratios, and estimating the implied expected rate of return
on equity capital, The Accounting Review 79, 7396.
Easton, Peter D., and Steven J. Monahan, 2005, An evaluation of accounting-based measures of
expected returns, The Accounting Review 80, 501538.
Elton, Edwin J., 1999, Expected return, realized return, and asset pricing tests, Journal of Finance
54, 11991220.
Elton, Edwin J., Martin J. Gruber, Deepak Agrawal, and Christopher Mann, 2001, Explaining the
rate spread on corporate bonds, Journal of Finance 56, 247278.
Fama, Eugene F., and Kenneth R. French, 1992, The cross-section of expected stock returns,
Journal of Finance 47, 427465.
Fama, Eugene F., and Kenneth R. French, 1995, Size and book-to-market factors in earnings and
returns, Journal of Finance 50, 131155.
Fama, Eugene F., and Kenneth R. French, 1997, Industry costs of equity, Journal of Financial
Economics 43, 153193.
Gebhardt, William R., Charles M. C. Lee, and Bhaskaran Swaminathan, 2001, Towards an ex-ante
cost of capital, Journal of Accounting Research 39, 135176.
Gode, Dan, and Partha Mohanram, 2003, Inferring the cost of capital using the Ohlson-Juettner
model, Review of Accounting Studies 8, 399431.
Graham, John R., Michael Lemmon, and Jack Wolf, 2002, Does corporate diversication destroy
value? Journal of Finance 57, 695720.
Hadlock, Charles J., and Joshua R. Pierce, 2010, New evidence on measuring nancial constraints:
Moving beyond the KZ Index, Review of Financial Studies 23, 19091940.
Higgins, Robert C., and Lawrence D. Schall, 1975, Corporate bankruptcy and conglomerate merger,
Hovakimian, Gayan e, 2011, Financial constraints and investment efciency: Internal capital allo-
cation across the business cycle, Journal of Financial Intermediation 20, 264283.
Hughes, John, Jing Liu, and Jun Liu, 2009, On the relation between expected returns and implied
cost of capital, Review of Accounting Studies 14, 246259.
Jegadeesh, Narasimhan, and Sheridan Titman, 1993, Returns to buying winners and selling losers:
Implications for stock market efciency, Journal of Finance 48, 6591.
Kim, E. Han, and John J. McConnell, 1977, Corporate mergers and the co-insurance of corporate
debt, Journal of Finance 32, 349365.
Kuppuswamy, Venkat, and Belen Villalonga, 2010, Does diversication create value in the presence
of external nancing constraints? Evidence fromthe 20072009 nancial crisis, Working paper,
Harvard Business School.
Lamont, Owen A., and Christopher Polk, 2001, Diversication discount: Cash ows vs. returns,
Lamont, Owen A., and Christopher Polk, 2002, Does diversication destroy value? Evidence from
the industry shocks, Journal of Financial Economics 63, 5177.
Lang, Larry H. P., and Ren e M. Stulz, 1994, Tobins Q, corporate diversication, and rm perfor-
mance, Journal of Political Economy 102, 12481280.
Lee, Charles M. C., David Ng, and Bhaskaran Swaminathan, 2009, Testing international asset
pricing models using implied costs of capital, Journal of Financial and Quantitative Analysis
44, 307335.
Lewellen, Wilbur G., 1971, A pure nancial rationale for the conglomerate merger, Journal of
Finance 26, 527537.
Liu, Jing, and Wei Su, 2005, Forecasting analysts forecast errors, Working paper, UCLA.
Livdan, Dmitry, Horacio Sapriza, and Lu Zhang, 2009, Financially constrained stock returns,
Mansi, Sattar, and David Reeb, 2002, Corporate diversication: What gets discounted? Journal of
Finance 57, 21672183.
Matsusaka, John G., and Vikram Nanda, 2002, Internal capital markets and corporate refocusing,
Journal of Financial Intermediation 1, 176211.
Merton, Robert C., 1974, On the pricing of corporate debt: The risk structure of interest rates,
Ogneva, Maria, K. R. Subramanyam, and K. Raghunandan, 2007, Internal control weakness and
cost of equity: Evidence from SOX Section 404 disclosures, The Accounting Review 82, 1255
1297.
Ortiz-Molina, Hern an, and Gordon Phillips, 2009, Asset liquidity and the cost of capital, Working
paper, University of Maryland.
P astor,

Lubo s, Meenakshi Sinha, and Bhaskaran Swaminathan, 2008, Estimating the intertem-
poral riskreturn tradeoff using the implied cost of capital, Journal of Finance 63, 28592897.
Petersen, Mitchell A., 2009, Estimating standard errors in nance panel data sets: Comparing
approaches, Review of Financial Studies 22, 435480.
Petkova, Ralitsa, and Lu Zhang, 2005, Is value riskier than growth? Journal of Financial Eco-
nomics 78, 187202.
Pulvino, Todd, 1998, Do asset re-sales exist? An empirical investigation of commercial aircraft
transactions, Journal of Finance 53, 939979.
Ross, Stephen A., Randolph W. Westereld, and Jeffrey Jaffe, 2008, Corporate Finance, 8
th
edition.
(McGraw-Hill, Irwin, New York, NY).
Schall, Lawrence D., 1972, Asset valuation, rm investment, and rm diversication, Journal of
Business 45, 1128.
Scott Jr., James H., 1977, On the theory of conglomerate mergers, Journal of Finance 32, 1235
1250.
Villalonga, Bel en, 2004, Does diversication cause the diversication discount? Financial Man-
agement 33, 523.
Whited, Toni M., and Guojun Wu, 2006, Financial constraints risk, Review of Financial Studies
19, 531559.
Yan, An, 2006, Value of conglomerates and capital market conditions, Financial Management 35,
530.
Yan, An, Zaihui Yang, and Jie Jiao, 2010, Conglomerate investment under various capital market
conditions, Journal of Banking and Finance 34, 103115.

Corporate Diversification and The Cost of Capital

Caricato da

Informazioni sul documento

Titolo originale

Copyright

Formati disponibili

Condividi questo documento

Condividi o incorpora il documento

Opzioni di condivisione

Hai trovato utile questo documento?

Questo contenuto è inappropriato?

Copyright:

Formati disponibili

Corporate Diversification and The Cost of Capital

Caricato da

Copyright:

Formati disponibili

THE JOURNAL OF FINANCE

VOL. LXVIII, NO. 5

Potrebbero piacerti anche