How increased diversification affects the efficiency of internal capital market?

This paper investigates the effect of increased diversification on the internal capital market. Previous literature examines the relationship of lowering diversification level and internal capital market. They find that internal capital market becomes more efficient as firms spin off poorly performing segments. This paper examines how the efficiency of the internal capital market changes after a firm adds new segments. It is demonstrated that for diversified firms, there is a strong and significant negative relationship between the number of segments and the diversity in investment opportunities. As previous literature shows that it is the diversity in investment opportunities among the segments of diversified firms that drives the internal capital market inefficiency, this may imply that firms with more segments may have a more efficient internal capital market than firms with fewer segments. The firms that become more diversified are better performers than firms that do not, after other variables that can affect firm value are controlled for. The results of this paper show that after firms add new segments, diversity in investment opportunities decreases. There are no significant changes in relative excess investment, efficiency of investment allocation, and excess value. The change in excess value is negatively related to the diversity measure, implying the firms that have the biggest decrease in diversity after being more diversified have largest increase in excess value.