Optimal Diversification: Reconciling Theory and Evidence

In this paper we show that the main empirical findings about firm diversification and performance are consistent with the maximization of shareholder value. In our model, diversification allows a firm to explore better productive opportunities while taking advantage of synergies. By explicitly linking the diversification strategies of the firm to differences in size and productivity, our model provides a natural laboratory to investigate several aspects of the relationship between diversification and performance. Specifically, we show that our model can rationalize the evidence on the diversification discount (<link rid="b18">Lang and Stulz (1994)</link>) and the documented relation between diversification and productivity (<link rid="b25">Schoar (2002)</link>). Copyright 2004 by The American Finance Association.