International Diversification And The Cost Of Capital: Is More Necessarily Better?

Abstract

This study examines the extent to which international diversification is a statistically significant predictor of the cost of capital among S&P 500 firms.  Existing research concerning the “diversification discount” suggests that the financial markets have become enamored with the idea that more tightly focused firms tend to be more profitable and, as a consequence, worth more.  Of interest here is the extent to which this same line of reasoning (i.e., less diversification is better) holds for international diversification.  The argument put forth here is that while international diversification may indeed be an avenue to higher sales and earnings, this may not be enough to enhance the market value of the firm because unless the additional profit yields a return on invested capital above the firm’s cost of capital, and unless that margin is adequate to satisfy existing investors and to attract new capital, the market value of the firm will decline.  To fully understand the likely consequences of broader international diversification or, correspondingly, a tighter strategic focus, one must understand how such diversification is apt to affect the firm’s cost of capital.  This study uses Herfindahl’s index of concentration to measure the degree of international diversification among the S&P 500 firms and this measure is subsequently regressed on the cost of capital.  What distinguishes this research is its focus on the relationship between a firm’s level of international diversification and its cost of capital, a strategically important construct that has been virtually ignored in the literature.