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Journal of Banking & Finance 30 (2006) 947–963

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Corporate governance, shareholder rights andfirm diversification: An empirical analysis

Pornsit Jiraporn a,*, Young Sang Kim b,1, Wallace N. Davidson c,2,Manohar Singh d,3

a Department of Accounting, Economics and Finance, Texas A&M International University, Laredo,

TX 78041, United Statesb Department of Economics and Finance, Northern Kentucky University, Highland Heights, KY 41099,

United Statesc Department of Finance, College of Business and Administration, Southern Illinois University,

Carbondale, United Statesd Atkinson Graduate School of Management, Willamette University, Salem, United States

Received 22 September 2004; accepted 29 August 2005Available online 7 December 2005

Abstract

Grounded in agency theory, this study investigates how the strength of shareholder rights influ-ences the extent of firm diversification and the excess value attributable to diversification. The empir-ical evidence reveals that the strength of shareholder rights is inversely related to the probability todiversify. Furthermore, firms where shareholder rights are more suppressed by restrictive corporategovernance suffer a deeper diversification discount. Specifically, we document a 1.1–1.4% decline infirm value for each additional governance provision imposed on shareholders. An explicit distinctionis made between global and industrial diversification. Our results support agency theory as an expla-nation for the value reduction in diversified firms. The evidence in favor of agency theory appears tobe more pronounced for industrial diversification than for global diversification.� 2005 Elsevier B.V. All rights reserved.

0378-4266/$ - see front matter � 2005 Elsevier B.V. All rights reserved.

doi:10.1016/j.jbankfin.2005.08.005

* Corresponding author. Tel.: +1 956 326 2518.E-mail addresses: [email protected] (P. Jiraporn), [email protected] (Y.S. Kim), [email protected]

(W.N. Davidson), [email protected] (M. Singh).1 Tel.: +1 859 572 5160.2 Tel.: +1 618 453 1429.3 Tel.: +1 503 698 1947.

948 P. Jiraporn et al. / Journal of Banking & Finance 30 (2006) 947–963

JEL classification: G30; G32; G34

Keywords: Diversification; Corporate governance; Shareholder rights

1. Introduction

Considerable research has explored the issue of corporate diversification. One criticalquestion is whether corporate diversification enhances or destroys value. Early researchersargued in favor of diversification citing factors such as greater operating efficiency, thepresence of an internal capital market, greater debt capacity, and lower taxes (for example,Fluck and Lynch, 1999; Bradley et al., 1998; Kaplan and Weisbach, 1992; Porter, 1987;Ravenscraft, 1987, among others).

On the contrary, several academic studies in the 1990�s provide evidence on the destruc-tive effect on firm value of corporate diversification (for example, Comment and Jarrell,1995; Liebeskind and Opler, 1995; Lang and Stulz, 1994; Servaes, 1996; Berger and Ofek,1995; Denis et al., 2002, among others). More recently, arguments have been advancedand new evidence presented that diversification may be beneficial or, at the minimum,not value-destroying (Villalonga, 2004; Whited, 2001; Campa and Kedia, 2002; Mansiand Reeb, 2002). Others have suggested that it may be the acquisition of poorly perform-ing units (Graham et al., 2002) or miscalculations of Tobin�s q (Whited, 2001) that explainthe diversification discount. Hence, the debate on the impact of diversification still contin-ues in the literature.

Motivated by agency theory, we contribute to the literature in this area by exploring therole of the agency costs in explaining the value discount (or premium?) caused by diversi-fication. In so doing, we examine the relation between firm value, corporate governance,shareholder rights and the propensity to diversify. We employ the governance index devel-oped by Gompers et al. (2003) to represent the strength of shareholder rights. Gomperset al. (2003) construct a governance index on the basis of how many corporate governanceprovisions exist that restrict shareholder rights, with a higher index indicating weakershareholder rights.

This study examines the influence of shareholder rights both on the extent of diversifi-cation and on the excess value arising from diversification. First, we investigate the rela-tion between the propensity to diversify and the strength of shareholder rights. We findevidence that firms where shareholder rights are weak are more likely to be industriallydiversified. This evidence is in favor of the explanation that managers exploit the weakshareholder rights and diversify the firm unwisely. As a result, industrially diversified firmsexhibit a reduction in value. The evidence on global diversification, however, is moreambiguous. We find no relation between the strength of shareholder rights and the pro-pensity to be diversified globally. Hence, global diversification does not appear to be moti-vated by managers taking advantage of weak shareholder rights. The value reductionaffiliated with global diversification (Denis et al., 2002), therefore, may not be explainedby the agency cost perspective.

Second, we investigate the impact of shareholder rights on firm value. To measure thevaluation effects, we use the concept of excess value, first developed by Berger and Ofek(1995). We document that more restrictive corporate governance is associated with lower

P. Jiraporn et al. / Journal of Banking & Finance 30 (2006) 947–963 949

excess value in diversified firms. Apparently, where shareholder rights are weaker, firmssuffer a more severe reduction in value. The detrimental effect on firm value of weak share-holder rights is found in all of the diversification categories except for global diversifica-tion. This evidence is consistent with an agency cost explanation. Diversified firmswhere shareholder rights are weak (and, therefore, management powers are strong) areexpected to suffer from acute agency costs created by the separation of ownership and con-trol. More specifically, we document that each additional restrictive governance provisionimposed on shareholders diminishes the excess value by approximately 1.1–1.4% onaverage.4

The study is organized as follows. We discuss our hypotheses in Section 2. The sampleselection criteria and data are discussed in Section 3. Then, Section 4 displays the empiricalevidence and, finally, Section 5 concludes.

2. Hypothesis development

2.1. Propensity to diversify and shareholder rights

Jensen (1986) argues that, when managers have access to free cash flow, they tend tospend it unwisely reducing shareholder wealth. There are several ways in which the freecash flow could be ‘‘wasted’’. One possibility might be for managers to consume extra per-quisites that are unnecessary. Another possibility could be managers attempting to expandthe firm through acquisitions in unrelated business segments that may not supply adequatereturns to shareholders. We make an explicit distinction between global and industrialdiversification and argue that weak shareholder rights enable managers to diversify thefirm (perhaps, unwisely) either globally or industrially or both. Hence, we hypothesizean inverse relation between the strength of shareholder rights and the propensity for diver-sification, the weaker the shareholder rights, the more diversified the firm is expected to be.Our first three hypotheses are related to the strength of shareholder rights and the propen-sity to diversify globally, industrially or both.

H1: When shareholder rights are more restricted, firms are more likely to be globallydiversified.

H2: When shareholder rights are more restricted, firms are more likely to be industriallydiversified.

H3: When shareholder rights are more restricted, firms are likely to be both globally andindustrially diversified.

2.2. Shareholder rights and firm value

As discussed earlier, we contend that weaker shareholder rights lead to a larger extentof corporate diversification either globally, industrially or both. The overall effects ofdiversification on firm value continue to be debated in the literature. Several studies

4 As shown later in the paper, the average firm has about 9 governance provisions. Thus, the average discountthat can be attributed to restrictions on shareholder rights is roughly 9.9–12.6%, which is both statistically andeconomically significant.

Industrial Diversification

Single-segment Multi-segment

Domestic

Single-segment Domestic

(SD)

Focused

Multi-segment Domestic

(MD)

Only industrially diversified

Global

Diversification

Global

Single-segment Global

(SG)

Only globally diversified

Multi-segment Global

(MG)

Both industrially and globally

diversified

Fig. 1. Global and industrial diversification classification. Single-segment firms operate in only one industrialsegment whereas multi-segment firms operate in more than one industrial segment. Domestic firms operate onlyin the US while global firms operate in, at least, one country outside the US. Single-segment Domestic firmsoperate in only one segment and only in the US. Multi-segment Domestic firms operate in more than oneindustrial segment but only in the US. Single-segment Global firms operate in only one industrial segment buthave a presence aboard. Multi-segment Global firms operate in more than one segment and also outside the US.


document a diversification discount whereas others offer evidence of a diversification pre-mium. Motivated by agency theory, we argue that diversification that results from agencyconflicts is likely to be value-destroying. Since agency conflicts are likely more severe infirms with weaker shareholder rights, we hypothesize a positive association between thestrength of shareholder rights and firm value.

H4: When shareholder rights are more restricted, firms experience a deeper diversifica-tion discount.

3. Sample selection and data

3.1. Sample selection

The initial sample is obtained from the Research Insight COMPUSTAT Industrial Seg-ment file (CIS) and the Geographic Segment file (CGS) over the period 1993–1998.5 A firmis classified as industrially diversified if it reports more than one segment in the CIS file. Afirm is regarded as geographically diversified if it reports foreign sales in the CGS file.6

5 Since the segment data are available only for active firms in COMPUSTAT, there may be some survivorshipbias in our sample. However, as noted by Denis et al. (2002), this bias may not be significant enough tocontaminate the results. In fact, our empirical results are similar to those of Denis et al. (2002), implying thatsurvivorship bias does not distort our results.

6 Under SFAS No. 14 (Statement of Financial Accounting Standards, 1976) and SEC Regulation S-K, firms arerequired to report information on industry and geographic segments whose sales, assets, or profits exceed 10% ofthe consolidated totals.

SDMD

SGMG

Total

1993

1995

1998

Total

423

279

507653

1862

176

108 180312

776

141

96 187185

609

10675 140

156

477

0

200

400

600

800

1000

1200

1400

1600

1800

2000

1993

1995

1998

Total

Fig. 2. Year distribution of the sample firms. SD stands for single-segment domestic, SG for single-segmentglobal, MD for multi-segment domestic, and MG for multi-segment global.


Firms are excluded that have segments in the financial industry (SIC codes 6000–6999)and the utility industry (SIC codes 4900–4999) because these industries are subject to reg-ulations, rendering the characteristics of their financial information incomparable to thosein other industries.7 We further reduce the sample by excluding those observations that donot have data on the governance index in the Investor Responsibility Research Center(IRRC). The IRRC collects data on corporate governance. However, the IRRC collectsdata only periodically and our sample is, therefore, restricted to the years in which theIRRC has data. For our study, we use data from 1993, 1995 and 1998.

Each firm in the final sample is, then, classified into one of the four diversification cat-egories. Fig. 1 shows the four diversification regimes classified along two diversification

7 Additional constraints are imposed as in Berger and Ofek (1995). We exclude firms with sales less than $20million and firms where the difference between the sum of the segment sales and total sales exceeds 1%.


dimensions, industrial and global. The final sample consists of a total of 1862 firm-yearobservations. Fig. 2 presents the year distribution of firms in the sample.

3.2. The governance index (GINDEX)

To measure the strength of shareholder rights, we employ the governance index (GIN-DEX) developed by Gompers et al. (2003)—henceforth GIM. They use data from theInvestor Responsibility Research Center (IRRC), which publishes detailed listings of cor-porate governance provisions for individual firms in Corporate Takeover Defenses (Rosen-baum, 1993, 1995, and 1998). The data on governance provisions are derived from various

Table 1Individual governance provisions employed in the construction of the governance index

Percentage of firms with governance provisions in

1993 1995 1998 Full sample

Delay

Blank check 82.60 86.70 87.37 85.93Classified board 63.52 64.04 58.89 61.76Special meeting 31.66 35.47 33.12 33.51Written consent 34.59 36.45 33.51 34.75

Protection

Compensation plans 67.92 73.89 61.73 67.29Contracts 16.98 14.45 12.11 14.12Golden parachutes 53.03 51.89 51.42 51.99Indemnification 40.04 38.42 25.39 33.44Liability 72.12 67.98 48.32 60.85Severance 4.61 87.03 12.50 9.24

Voting

Bylaws 15.93 15.11 16.75 16.00Charter 2.52 2.63 2.96 2.74Cumulative voting 14.05 13.46 10.70 12.46Secret ballot (confidential voting) 14.47 14.29 9.41 12.30Supermajority 21.80 20.03 15.21 18.47Unequal voting 2.94 2.46 1.93 2.36

Other

Anti-greenmail 8.18 7.88 5.67 7.04Directors� duties 8.18 7.39 6.19 7.09Fair price 38.57 34.98 2.60 3.22Pension parachutes 7.55 5.25 2.96 4.89Poison pill 63.30 60.92 56.44 59.67Silver parachutes 17.34 4.60 2.96 4.62

State

Anti-greenmail law 16.56 15.44 13.27 14.82Business combination law 91.20 90.80 92.27 91.51Cash-out law 3.56 3.12 2.45 2.95Directors� duties law 4.82 3.95 3.74 4.08Fair price law 32.49 31.52 29.38 30.88Control share acquisition law 2.47 24.96 22.68 23.95

Governance index 9.63 9.59 8.87 9.30

The detailed explanation for each governance provision is available in the Appendix of Gompers et al. (2003).


sources, such as corporate bylaws, charters, proxy statements, annual reports, as well as10-K and 10-Q documents filed with the Security and Exchange Commission (SEC).The individual governance provisions included in the construction of the governance indexare displayed in Table 1. They classify provisions into 5 categories: tactics for delayinghostile bidders (Delay); voting rights (Voting); director/officer protection (Protection);other takeover defenses (Other); and state laws (State).8 Table 1 shows the percentageof firms in our sample that have each provision in each sample year.

The governance index is constructed as follows; for every firm, GIM add one point forevery provision that restricts shareholder rights (increases managerial power). While thisindex does not accurately reflect the relative impacts of the various provisions, it hasthe advantage of being transparent and easily reproducible. The index does not requireany judgments about the efficacy or wealth effects of any of these provisions; GIM onlyconsiders the impact on the balance of power.

To clarify the logic behind the construction of the governance index, GIM use the fol-lowing example; consider classified boards, a provision that staggers the terms and elec-tions of directors and, thus, can be employed to slow down a hostile takeover. Ifmanagement uses this power judiciously, it could possibly lead to an increase in overallshareholder wealth; if management, however, uses this power to maintain private benefitsof control, then this provision would diminish shareholder wealth. Either way, it is appar-ent that classified boards enhance the power of managers and weaken the control rights oflarge shareholders. Hence, the governance index captures the balance of power betweenmanagement and shareholders.

Most provisions other than classified boards can be viewed with the same logic. Almostevery provision enables management to resist different types of shareholder activism, suchas calling special meetings, changing the firm�s charter or bylaws, suing the directors, orreplacing them all at once. GIM note, however, that there are two exceptions, secret bal-lots (confidential voting) and cumulative voting. A secret ballot or confidential voting des-ignates a third party to count proxy votes and, therefore, prevents management fromobserving how specific shareholders vote. Cumulative voting enables shareholders to con-centrate their directors� votes so that a large minority shareholder can ensure some boardrepresentation. These two provisions are usually proposed by shareholders and opposedby management because they enhance shareholder rights and diminish the power of man-agement. Thus, for each one, GIM add one point to the governance index when firms donot have it. For all other provisions, GIM add one point when firms do have each of theprovisions. In summary, the governance index is simply the sum of one point for the pres-ence (or absence) of each provision.

3.3. Excess value

To measure the value of globally and industrially diversified firms, we use the excessvalue measure following the modified version of Berger and Ofek (1995). We use the sin-gle-segment domestic firm as the benchmark to compute excess value.9 The excess value

8 The detailed explanation for each governance provision is available in the appendix of GIM.9 We argue that the excess value measure is superior to Tobin�s q (Lang and Stulz, 1994) because Tobin�s q

requires replacement cost in the denominator and neither foreign inflation rates nor the exchange rate effect aretaken into account.


measure is computed following Berger and Ofek (1995) with the modification in Bodnaret al. (1999), and is defined as follows:

EVi;t ¼ logðMVi;t=Imputed Valuei;tÞ;Imputed Valuei;t ¼

XðSSalei;t �MultiplierÞ;

where: EVi,t is the excess value for firm i in year t; MVi,t is the firm�s market capitalization(market value of common equity plus book value of debt) for firm i in year t; and ImputedValue is the sum of segment sales multiplied by the sales multiplier. The Multiplier is mea-sured as the median total market capitalization to sales for the single-segment domesticfirms in the same industry in the same year. A positive excess value indicates that the entirefirm is worth as a whole more than the sum of its segments whereas a negative excess valueshows that the firm as a whole is worth less than the sum of its segments. Thus, a positiveexcess value implies a diversification premium while a negative excess value indicates adiversification discount.

4. Empirical evidence

4.1. Summary statistics

Descriptive statistics for selected firm characteristics for our sample appear in Table 2(Panel A). The multi-segment domestic firm is not significantly larger than its single-

Table 2Summary statistics

Domestic Global FullsampleSD MD t-Statistics SG MG t-Statistics

Panel A: Descriptive statisticsa

Sales 2605.62 2846.33 �0.60 2910.84 6093.02 �5.51*** 3947.82Total assets 2021.95 2575.76 �1.66* 2725.20 6524.77 �5.13*** 3875.55Debt ratiob 21.85% 26.02% �2.87*** 19.43% 26.24% �7.35*** 23.36%EBIT/sales 7.73% 9.50% �1.55 10.52% 10.03% 0.67 9.56%CAPX/sales 10.72% 6.90% 3.81*** 9.93% 7.51% 2.64*** 8.80%R&D/sales 3.89% 0.63% 3.39*** 6.06% 3.01% 6.98*** 3.69%Advertising/sales 10.85% 8.26% 1.35 13.10% 14.20% �0.52 12.25%% Managerial ownership 14.13% 12.69% 0.92 10.74% 8.46% 2.39** 11.03%

Mean (%) Median (%) N SD

Panel B: Excess value by type of diversification

Multi-segment domestic (MD) 5.47 0.34 279 49.24Single-segment global (SG) 9.17 10.18 507 62.34Multi-segment global (MG) 9.57 7.66 653 53.89Single-segment domestic (SD) 24.66 24.65 423 50.74

Total 12.28% 11.39% 1862 55.38

* Statistically significant at the 10% level.** Statistically significant at the 5% level.

*** Statistically significant at the 1% level.a SD stands for single-segment domestic, SG for single-segment global, MD for multi-segment domestic, and

MG for multi-segment global.b The debt ratio is calculated as total debt divided by total assets.

Table 3Univariate tests for the governance index

Single-segmentmean (median)

Multi-segmentmean (median)

t-TestZ-score

Domestic vs.global

Domestic 8.53 9.74 �5.51*** 9.018.00 10.00 �5.31*** 9.00

N (423) (279) (702)

Global 8.96 9.87 �5.53*** 9.479.00 10.00 �5.65*** 10.00

N (507) (653) (1160)

t-Test �2.24** �0.65 �3.37***

Z-score �2.14** �0.93 �3.55***

Single-segment vs.Multi-segment

8.73 9.83 �8.23***

9.00 10.00 �8.21***

N (930) (932)


*** Statistically significant at the 1% level.


segment counterpart in terms of sales but significantly larger in terms of total assets (2605.62vs. 2846.33 in sales and 2021.95 vs. 2575.76 in total assets). Multi-segment global firms,however, are considerably larger than single-segment firms both in terms of sales and totalassets (2910.84 vs. 6093.77 in sales and 2725.20 vs. 6524.77 in total assets). Multi-segmentfirms have larger debt ratios, smaller capital expenditures, and smaller R&D expenditures.Likewise, global firms have larger debt ratios, lower capital expenditures and smaller R&Dexpenditures. In terms of managerial (executives and board members) ownership, there isno significant difference between single-segment domestic (SD) firms and multi-segmentdomestic (MD) firms (14.13% vs. 12.69%). However, the difference is significant betweensingle-segment global (SG) firms and multi-segment global (MG) firms (10.74% vs. 8.46%).

Panel B of Table 2 displays the excess value10 by diversification type. It should be notedthat the excess value for single-segment domestic firms is the highest, suggesting thatfocused firms are more valuable. As mentioned earlier, we do not concentrate on ascertain-ing whether the excess value is, on average, positive or negative. Rather, our focus is ondetermining the association between the excess value and the strength of shareholderrights.

4.2. Propensity to diversify and shareholder rights

Table 3 presents the univariate analysis for the governance index and the extent of firmdiversification. In the last column, we test domestic firms against global firms regardless of

10 The excess value is constructed as described in Berger and Ofek (1995). The benchmark firm is the single-segment domestic firm. In computing the excess value, we use the entire universe of firms with available data onCOMPUSTAT. Then, we retain only the observations where the governance index is available. The summarystatistics shown here are only for the observations that remain in the final sample. Firms that are followed by theIRRC tend to be large and well established. Hence, firms with low excess value are, perhaps, less likely to beincluded. This may explain why both the mean and the median are positive although diversification is found to bevalue-destroying.

Table 4Logistic regressions predicting global and industrial diversification with the governance index and controls

Dependent dichotomousvariable

Model 1(Wald statistics)




Global Industrial Global Industrial

Intercept �1.100*** �2.111*** �0.967*** �2.113***

(34.20) (126.17) (15.20) (73.25)Governance index �0.100 0.099*** �0.015 0.112***

(0.26) (30.82) (0.34) (20.70)Relative log (total assets) 0.693*** 0.457*** 0.711*** 0.449***

(236.99) (149.27) (125.88) (72.97)Relative R&D to sales �2.137** �0.756 �3.136 �0.689

(5.81) (1.19) (6.92) (0.66)Managerial ownership (%) – – 0.000 0.000

(0.89) (0.48)

No. of observations 1862 1862 1006 1006Pseudo R2 22.4% 16.2% 22.5% 16.2%

The governance index is as defined in Gompers et al. (2003). Excess value is calculated based on Berger and Ofek(1995).




whether they are industrially diversified or not. The average number of governance provi-sion for the domestic firm is 9.01 (median 9.00) and that for the global firm is 9.47 (median10.00). The different is statistically significant at the 1% level both in the t-test and in thedistribution-free non-parametric test (Z-score). The evidence reveals that weaker share-holder rights (more restrictive governance) are associated with global diversification.

In the last row of Table 3, we compare single-segment firms with multi-segment firms,regardless of whether they operate globally or just domestically. The average number ofgovernance provisions of the single-segment firm is 8.73 (median 9.00) while that forthe multi-segment firm is 9.83 (median 10.00). The difference is statistically significant atthe 1% level. Firms where shareholder rights are weak seem to be industrially diversified.

We also divide the sample further into single-segment domestic (SD), single-segmentglobal (SG), multi-segment domestic (MG) and multi-segment global (MD) firms. Themulti-segment global firm (MG) has 9.87 governance provisions on average (median10.00). This is higher than the numbers of governance provisions in the other three groups.The results imply that weaker shareholder rights are associated with a combination ofboth global and industrial diversification.

We enhance the univariate analysis with a logistic regression analysis presented in Table4. A number of control variables are included.11 First, several prior studies show that firmsize impacts the extent of corporate diversification. For instance, Denis et al. (1997) pro-vide evidence that the number of business segments in which a firm operates is positivelyrelated to firm size. Similarly, Singh et al. (2004) provide evidence that firm size is a

11 Alternative control variables are used and produce qualitatively similar results. To capture the potentialindustry effects, we industry-adjust the control variables by subtracting the industry median from the value ofeach variable for a given firm. The first two digits of the SIC codes are employed to identify the industry.

Table 5Multinomial logistic regression predicting firm diversification with the governance index and controls

MD (Wald statistics) SG (Wald statistics) MG (Wald statistics)

Intercept �2.361*** �1.252*** �3.108***

(66.75) (26.81) (131.51)Governance index 0.115*** �0.002 0.088***

(16.37) (0.00) (11.64)Relative log (total assets) 0.466*** 0.700*** 1.121***

(45.52) (127.23) (298.16)Relative R&D to sales �1.397 �2.650** �2.664

(1.56) (6.07) (5.14)

Pseudo R2 26.7%

The governance index is as defined in Gompers et al. (2003). Excess value is calculated based on Berger and Ofek(1995).




positive predictor of firm diversification in that larger firms have greater propensity to bediversified. As a result, we employ the logarithm of total assets to control for firm size.Furthermore, Denis et al. (1997) suggest that certain firms are characterized by the needfor large amounts of firm-specific knowledge that is not easily transferable to other linesof business. Thus, we control for firm-specific knowledge by including a measure ofR&D intensity (R&D/Sales). Finally, within Jensen�s agency framework (1986), firmswhere managerial ownership is high tend to have shareholders� and managers� interestsbetter aligned and, therefore, suffer less agency costs. Morck et al. (1988) and McConnelland Servaes (1990) provide evidence of a predominantly positive relation between corpo-rate value and managerial ownership. With respect to the relation between diversificationand agency costs, managerial ownership is found to be an important determinant of cor-porate diversification (Denis et al., 1997). Thus, we include managerial ownership as acontrol variable as well.12

In Model 1, the dependent variable is a dichotomous variable that is equal to 1 if thefirm is globally diversified and 0 otherwise. The coefficient of the governance index inModel 1 is not statistically significant, suggesting no relation between the strength ofshareholder rights and the propensity to be globally diversified. Thus, hypothesis 1 (H1)does not seem to be supported here.

In Model 2, the dependent variable is a dichotomous variable that takes the value of 1 ifthe firm is industrially diversified and 0 otherwise. The governance index has a positive andhighly significant coefficient. Hence, a higher number of governance provisions that limitshareholder rights are associated with a higher probability to be industrially diversified. Thisevidence is consistent with hypothesis 2 (H2). In Models 3 and 4, we include managerial own-ership as a control variable13 and obtain qualitatively similar results on the governance index.

12 Our managerial ownership variable measures the direct stock ownership by managers and board of directorsand is computed as the number of shares of stock held by the executives and board members as a percentage oftotal shares outstanding.13 The data on managerial ownership are available for only 1006 observations in the sample. Hence, we include

managerial ownership in a separate set of regressions.


To test hypothesis 3 (H3), we estimate a multinomial logistic regression where thedependent variable is a discrete variable that takes on four possible values (1 if single-segment domestic (SD), 2 if multi-segment domestic (MD), 3 if single-segment global(SG) and 4 if multi-segment global (MG)). These four diversification regimes representthe four possible combinations of global and industrial diversification. The results of themultinomial logistic regression are displayed in Table 5. The last column of the tableshows the results for the multi-segment global (MG) firm. This group represents firmsthat are both globally and industrially diversified. The governance index has a positiveand significant estimated coefficient.14 The evidence indicates that a higher number ofgovernance provisions (weaker shareholder rights) contributes to a greater likelihoodthat the firm is both globally and industrially diversified. The evidence lends supportto hypothesis 3 (H3).15

In conclusion, we find support for H2 and H3 but not for H1. More restrictive gover-nance, which suppresses shareholder rights, is associated with a higher degree of industrialdiversification and the combination of both global and industrial diversification (but notglobal diversification alone).

4.3. Shareholder rights and firm value

We test H4 in a multiple regression framework to control for firm specific character-istics other than governance and diversification attributes. In Table 6, the results of aregression analysis are shown. The dependent variable is the excess value (calculatedas in Berger and Ofek, 1995). The test variable is the governance index. A number ofcontrol variables are included; global and industrial diversification, firm size (Log (totalassets)), profitability (EBIT/sales), debt ratio, growth opportunities (CAPX/sales), infor-mational asymmetry (R&D/sales), advertising expenses, and percentage of managerialownership.16

We run two sets of regressions. First, we attempt to replicate the results of other pre-vious studies by regressing the excess value on the diversification dummies and the controlvariables. Then, in the second set of regressions, we add the governance index in theregressions to ascertain the impact of the strength of shareholder rights on firm value.In the first three models in Table 6 (where the governance index is not included), all ofthe diversification dummies (except the global dummy17) exhibit negative and significantcoefficients, suggesting that diversification reduces firm value.

14 An alternative regression is run where managerial ownership is included (results omitted). The results remainsimilar.15 It can be argued that governance structure and diversification are endogenously determined. If this is the case,

then, the simultaneous equations framework may be more suitable for testing H1, H2, and H3. As a robustnesscheck, we run Hausman�s specification test to check for the presence of simultaneity. The Hausman tests are allstatistically insignificant. There is no evidence of simultaneity. We conclude that endogeneity does not seem toimpact the results.16 These control variables are employed in a number of prior studies on diversification (Denis et al., 2002; Berger

and Ofek, 1995; among others).17 The coefficient of the global dummy is significant at the 15% level, however.

Table 6

Regressions of the excess value on the governance index, global and industrial diversification dummies and controls

Model 1

(t-statistics)

Model 2

(t-statistics)

Model 3

(t-statistics)

Model 4

(t-statistics)

Model 5

(t-statistics)

Model 6

(t-statistics)

Model 7

(t-statistics)

Intercept 0.022 0.036 0.079** 0.135** 0.123** 0.168*** 0.117***

(0.662) (1.11) (2.10) (2.38) (2.22) (2.87) (2.73)

Governance index – – – �0.014** �0.011* �0.011** –

(�2.45) (�1.94) (�1.98)

Global �0.051 – – �0.052 – – –

(�1.42) (�1.45)

Multi-segment – �0.120*** – – �0.110*** – –

(�3.58) (�3.26)

Multi-segment domestic – – �0.199*** – – �0.189*** �0.193***

(�3.74) (�3.55) (�3.62)

Single-segment global – – �0.101** – – �0.103** �0.102**

(�2.17) (�2.22) (�2.18)

Multi-segment global – – �0.168*** – – �0.160*** �0.162***

(�3.54) (�3.36) (�3.41)

Entrenchment index

(Bebchuk et al., 2004)

– – – – – – �0.022***

(�1.82)

Relative log (total assets) 0.048*** 0.055*** 0.060*** 0.055*** 0.060*** 0.065*** 0.062***

(3.83) (4.51) (4.67) (4.31) (4.81) (4.96) (4.80)

Relative EBIT to sales 1.098*** 1.060*** 1.065*** 1.074*** 1.043*** 1.047*** 1.050***

(8.43) (8.18) (8.21) (8.24) (8.04) (8.07) (8.10)

Relative debt ratio �0.326*** �0.335*** �0.334*** �0.329*** �0.339*** �0.337*** �0.330***

(�3.64) (�3.79) (�3.75) (�3.68) (�3.83) (�3.79) (�3.71)

Relative capital

expenditures to sales

1.054*** 1.028*** 1.018*** 1.035*** 1.017*** 1.006*** 1.021***

(7.23) (7.09) (7.01) (7.10) (7.02) (6.93) (7.04)

Relative R&D to sales 1.490*** 1.471*** 1.447*** 1.479*** 1.464*** 1.440*** 1.431***

(6.19) (6.15) (6.05) (6.16) (6.13) (6.03) (5.99)

Relative advertising

expense to sales

1.458*** 1.403** 1.450*** 1.389** 1.349*** 1.400** 1.403**

(2.64) (2.55) (2.64) (2.51) (2.46) (2.54) (2.56)

% Managerial ownership 0.000* 0.000** 0.000** 0.000* 0.000* 0.000* 0.000*

(1.82) (1.97) (2.02) (1.67) (1.85) (1.90) (1.90)

No. of observations 971 971 971 971 971 971 971

F-statistics 21.55*** 23.14*** 19.10*** 19.92*** 21.04*** 17.77*** 17.71***

Adjusted R2 14.5% 15.4% 15.7% 15.7% 16.5% 16.9% 16.9%

Excess Value is computed as described in Berger and Ofek (1995). The governance index is constructed based on Gompers et al.

(2003). Global is equal to one if the firm is globally diversified regardless of whether it is industrially diversified or not, zero

otherwise. Multi-segment is equal to one if the firm is industrially diversified regardless of whether it is globally diversified or not,

zero otherwise. Multi-segment domestic is equal to one if the firm is diversified industrially but not globally, zero otherwise.

Single-segment global is equal to one if the firm is diversified globally but not industrially, zero otherwise. Multi-segment global is

equal to one if the firm diversified both industrially and globally, zero otherwise.* Statistically significant at the 10% level.

** Statistically significant at the 5% level.*** Statistically significant at the 1% level.


Then, to determine the impact of the strength of shareholder rights on firm value, weadd the governance index in Models 4, 5, and 6. In Model 4, we include the governanceindex, the global diversification dummy, and the control variables. The estimated coeffi-cient of the governance index is negative and statistically significant. The evidence is con-sistent with the hypothesis that firms where shareholder rights are restricted (highGINDEX) experience low excess value. In Model 5, we replace the global dummy withthe multi-segment dummy. The estimated coefficient for the governance index remainsnegative and significant. In Model 6, we use various diversification dummies to capturethe influence of dual-global and industrialdiversification strategies and obtain similar

Table 7Regressions of the excess value on the interaction terms and controlsa excess value is computed as described inBerger and Ofek (1995)

Model 1(t-statistics)





Intercept 0.111*** 0.104** 0.074 0.070 0.058(2.45) (2.32) (1.27) (1.21) (0.93)

Governance index · global �0.009*** – �0.003 – –(�3.41) (�0.12)

Governance index · multi-segment �0.005* – �0.010*** – –(�1.94) (�3.00)

Governance index· multi-segment domestic

– �0.018*** – �0.019*** �0.016**

(�4.33) (�3.90) (�2.51)Governance index

· single-segment global– �0.020*** – �0.011* �0.007

(�5.22) (�1.88) (�1.15)Governance index

· multi-segment global– �0.018*** – �0.014*** �0.011*

(�4.61) (�2.71) (�1.82)Governance index �0.008* �0.002 �0.005 �0.001 �0.003

(�1.69) (�0.33) (�1.13) (�0.33) (�0.44)% Managerial ownership

· multi-segment domestic– – – – �0.002

(�1.11)% Managerial ownership

· single-segment global– – – – �0.003

(�1.19)% Managerial ownership

· multi-segment global– – – – �0.003

(�0.97)Managerial ownership (%) – – 0.000* 0.00* 0.002

(1.61) (1.69) (1.13)

Control variables included Yes Yes Yes Yes YesNo. of observations 1862 1862 971 971 971F-statistics 32.70*** 31.24*** 18.60*** 17.41*** 13.81***

Adjusted R2 13.3% 14.0% 15.4% 15.7% 16.8%

The governance index is constructed based on Gompers et al. (2003). Global is equal to one if the firm is globallydiversified regardless of whether it is industrially diversified or not, zero otherwise. Multi-segment is equal to oneif the firm is industrially diversified regardless of whether it is globally diversified or not, zero otherwise. Multi-segment domestic is equal to one if the firm is diversified industrially but not globally, zero otherwise. Single-segment global is equal to one if the firm is diversified globally but not industrially, zero otherwise. Multi-segmentglobal is equal to one if the firm diversified both industrially and globally, zero otherwise.


*** Statistically significant at the 1% level.a We also run additional regressions by diversification type and obtain qualitatively similar results except for

the multi-segment global firm.


results. The results suggest that firms with weak shareholder rights (restrictive governance)suffer a deeper diversification discount.18 The predictions of H4 are, therefore, supported.

18 As a robustness check, we replace the global dummy with foreign sales as a continuous alternative measure ofglobal diversification and re-run the regression (results omitted). The results are similar. Likewise, we replace themulti-segment dummy with the Herfindahl index as a continuous alternative measure of industrial diversificationand re-run the regression (results not shown). The results are, again, consistent with the results arrived at usingdummy variable specification.


The estimated coefficient of the governance index varies from �0.011 to �0.014, indi-cating that for each additional governance provision imposed on shareholder rights, theexcess value declines by approximately 1.1–1.4%. Because the average firm in the samplehas about 9 governance provisions, the average discount on firm value is about 9.9–12.6%that can be attributed to the suppression of shareholder rights through strict corporategovernance. A discount of this magnitude is both statistically and economically significant.

Finally, a recently study by Bebchuk et al. (2004) constructs an ‘‘Entrenchment Index’’based on 6 of the 24 governance provisions19 in Gompers et al. (2003). They contend thatthis index can better explain firm value (represented by Tobin�s q) and stock returns thanthe governance index- specifically, the higher the Entrenchment Index, the lower the firmvalue. Following Bebchuk et al. (2004), we create the Entrenchment Index and include it inthe regression in Model 7. The coefficient of the Entrenchment Index is negative and sig-nificant, suggesting that managerial entrenchment is associated with a value reduction.Therefore, our results agree with those in Bebchuk et al. (2004).

We now examine whether the detrimental effect is uniform across different diversifica-tion categories. We accomplish this by constructing a number of interaction terms betweenthe governance index and the various diversification dummies. The results of the regres-sions with the interaction terms appear in Table 7. Model 1 includes two interaction terms,one that combines the governance index with the global dummy variable and another thatcombines the governance index with the multi-segment dummy variable. Both of theseinteraction terms produce negative and significant estimated coefficients. The results revealthat restrictive governance reduces firm value both in the presence of global diversificationand industrial diversification.20

In Model 2, we include three interaction terms in the regression, each term correspond-ing to the governance index interacting with each diversification dummy. All of the inter-action terms in Model 2 display negative and statistically significant estimated coefficients,implying that restrictive governance provisions destroy value in all of these diversificationcategories.

We repeat the previous regressions in Models 3 and 4 but add managerial ownership asa control variable. Interestingly, in Model 3, when managerial ownership is included, theestimated coefficient of the interaction term between the governance index and globaldiversification becomes insignificant. The results for the rest of the interaction terms arequalitatively similar to those in Models 1 and 2. The results in Model 3 indicate that, aftercontrolling for managerial ownership, restrictive governance (weak shareholder rights)does not reduce the excess value in firms that are globally diversified. It does so, however,in the other diversification regimes.

Finally, in Model 5, we control for the interaction effects between managerial owner-ship and diversification. The three variables that interact ownership with the diversifica-tion dummies are added as controls in Model 5. The results in Model 5 are similar to

19 The six provisions included in the Entrenchment Index are staggered boards, limits to shareholder bylawamendments, supermajority requirements for mergers, supermajority requirements for charter amendments,poison pills, and golden parachutes.20 In addition, the estimated coefficient for the governance index is negative and significant. This negative sign

suggests that weak shareholder rights may, perhaps, exacerbate the agency problem and is associated withreduced value. However, this variable becomes insignificant in later models (and is only significant at the 0.10level in Model 1) so the evidence that weak shareholder rights reduce value may be marginal, at best.


those in Model 4 except for the interaction term between the governance index and thesingle-segment global dummy, which loses its significance. This is hardly surprising, how-ever, given that the governance index does not explain global diversification as much asindustrial diversification in the previous analyses.

In summary, there is a positive (negative) relationship between the strength of share-holder rights (corporate governance) and firm value. The diversification discount is moresevere when the firm has more governance provisions that restrict shareholder rights. Thisrelation does hold in all of the diversification categories except for global diversificationeven after controlling for ownership structure.

5. Concluding remarks

Because of the on-going debate on the costs and benefits of diversification, we contrib-ute to the literature by empirically examining the potential connections between corporategovernance, shareholder rights, firm value, and the propensity for a firm to be diversified.The governance index developed by Gompers et al. (2003) is employed as the measure ofthe strength of shareholder rights. There is evidence that when shareholder rights are morerestricted, the firm is more likely to be diversified. We argue that weak shareholder rightsallow management to diversify the firm unwisely, resulting in a decline in value.

The excess value developed by Berger and Ofek (1995) is used as a proxy for firm value.The evidence in our study reveals that firms where shareholder rights are more suppressedby restrictive governance provisions suffer a deeper diversification discount. This is true forall diversification categories except for global diversification. When shareholder rights areweak, agency costs created by the separation of ownership and control are likely to bemore acute. As a result, the diversification discount is more severe.

Our study contributes to the literature both in corporate diversification and agency the-ory. In corporate diversification, our results complement findings of those studies thatidentify agency costs as responsible for the value reduction (Denis et al., 1997; Hylandand Diltz, 2002, among others). Consistent with the agency theory perspective, we demon-strate that restrictive corporate governance provisions may enable management to pursuestrategies that are not necessarily consistent with shareholders� wealth maximization (inthis particular instance, suboptimal diversification that destroys firm value). Our studyalso contributes by considering the relative effects of global and industrial diversificationseparately whereas most other studies take into account only industrial diversification(with a notable exception of Denis et al., 2002).

In conclusion, our results complement those of Denis et al. (1997). Both studies findempirical support for agency theory. Unlike Denis et al. (1997), however, our focus ison the strength of shareholder rights and corporate governance whereas theirs is on man-agerial ownership. The results of both studies, nevertheless, are remarkably similar in thesense that they provide support for agency conflict as responsible for the diversificationdiscount.

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