Financial Constraints, Managerial Incentives and the Scope of the Firm

The recent seminal work of Gabaix (2011) raises a puzzling question: If centralization-putting different projects under the same roof-reduces diversification for investors, how does this situation reconcile with the seemingly contradictory fact that it also boosts a firm's borrowing capacity? To address this puzzle, we propose a theory where centralization increases the correlation across projects by exposing them to the shock of the same CEO. We show that, in contrast to the conventional wisdom, such increased correlation enhances rather than reduces the firm's ability to relax financial constraints because more correlated shocks can better take advantage of cross pledging possibilities