Why Do Managers Diversify Their Firms?Agency Reconsidered

Rajesh K. AggarwalAmos Tuck SchoolDartmouth College

Hanover, NH 03755Rajesh.Aggarwal@dartmouth.edu

(603) 646-2843

Andrew A. SamwickDepartment of Economics

Dartmouth CollegeHanover, NH 03755

Andrew.Samwick@dartmouth.edu(603) 646-2893

March, 2000

Abstract: The existing agency explanation for corporate diversification is based on theexistence of a diversification discount and a negative relationship between diversificationand managerial ownership. We argue that this explanation is incomplete on boththeoretical and empirical grounds. We develop a contracting model betweenshareholders and managers in which optimal incentive contracts mitigate managers’propensity to diversify. We derive comparative static predictions for the equilibriumrelationships between incentives, diversification, and firm performance. The model isconsistent with the observed negative relationship between corporate diversification andfirm value. Empirically, we show that the negative relationship that has been observedbetween diversification and managerial incentives is the result of omitted variable bias.When estimated using panel data, higher managerial incentives are associated withgreater diversification. We also find that the link between firm performance andmanagerial incentives is weaker for firms that experience changes in diversification thanit is for firms that do not experience changes in diversification. These two findingsprovide support for our agency cost explanation for diversification, in which observedchanges in diversification and incentives within firms are equilibrium responses tochanges in the level of benefits that managers derive from diversification.

We thank Sheri Aggarwal, Andrew Bernard, Michael Knetter, Praveen Kopalle, Dominic LaValle, DennisLogue, Joel Vanden, and seminar participants at Dartmouth for helpful discussions. We also thank BobBurnham for assistance with Compustat and Andy Halula for assistance with the ExecuComp database.Any errors are our own.

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Frpphqw/ Urehuw dqg Juhj D1 Mduuhoo +4<<8,1 �Frusrudwh Irfxv dqg Vwrfn Uhwxuqv1�Mrxuqdo ri Ilqdqfldo Hfrqrplfv1 6:= 9:0;:1

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63

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Vhuydhv/ Khqul +4<<9,1 �Wkh Ydoxh ri Glyhuvl�fdwlrq Gxulqj wkh Frqjorphudwh PhujhuZdyh1� Mrxuqdo ri Ilqdqfh1 84= 4534045581

Vkohlihu/ Dqguhl dqg Urehuw Ylvkq| +4<;<,1 �Pdqdjhphqw Hqwuhqfkphqw�Wkh Fdvh riPdqdjhu0Vshfl�f Lqyhvwphqwv1� Mrxuqdo ri Ilqdqfldo Hfrqrplfv1 58= 456046<1

Vkohlihu/ Dqguhl dqg Urehuw Ylvkq| +4<<:,1 �D Vxuyh| ri Frusrudwh Jryhuqdqfh1� Mrxuqdori Ilqdqfh1 85= :6:0;61

Vwxo}/ Uhqh P1 +4<<3,1 �Pdqdjhuldo Glvfuhwlrq dqg Rswlpdo Ilqdqflqj Srolflhv1� Mrxuqdori Ilqdqfldo Hfrqrplfv1 59= 605:1

Vwdqgdug dqg Srru*v +4<<8,1 V)S Frpsxvwdw H{hfxFrps= Wkh H{hfxwlyh FrpshqvdwlrqGdwdedvh1 Hqjohzrrg/ FR= PfJudz0Kloo/ Qryhpehu1

Vwhlq/ Mhuhp| F1 +4<<:,1 �Lqwhuqdo Fdslwdo Pdunhwv dqg wkh Frpshwlwlrq iru FrusrudwhUhvrxufhv1� Mrxuqdo ri Ilqdqfh1 85= 44404661

64

32

Table 1Descriptive Statistics for Variables Used in Econometric Analyses

VariableNumber of

Observations MeanStandardDeviation

10th

Percentile25th

Percentile Median75th

Percentile90th

Percentile

Team PPS 7045 7.1269 10.7508 0.4491 1.1308 3.1259 7.1269 19.4998 CEO PPS 7045 4.1565 7.3757 0.1550 0.4583 1.3371 3.9261 11.8047Tobin’s Q 7045 2.1397 2.1263 1.0666 1.2479 1.6002 2.3375 3.6263No. of Segments 7045 2.1796 1.8230 1.0000 1.0000 1.0000 3.0000 4.0000No. of 4-digit SICs 7045 1.7918 1.2110 1.0000 1.0000 1.0000 2.0000 3.0000No. of 2-digit SICs 7045 1.5517 0.9517 1.0000 1.0000 1.0000 2.0000 3.0000Investment/Capital 7045 0.2543 0.1731 0.0845 0.1377 0.2106 0.3308 0.4815Dividend Yield 7045 1.4928 2.1584 0.0000 0.0000 0.8700 2.3500 4.0200Ln(sales) 7045 7.0342 1.5832 5.1308 6.0369 6.9847 8.0879 9.0983Capital/Sales 7045 0.5385 0.8911 0.0703 0.1318 0.2573 0.5576 1.4390Cash Flow/Capital 7045 0.8628 2.7421 0.1471 0.2461 0.4941 0.9321 1.8251Debt/Assets 7015 0.2338 0.1818 0.0033 0.0828 0.2236 0.3472 0.4461Std Dev of Returns 6814 669.65 1491.69 61.70 106.20 235.82 601.38 1393.56R & D/Capital 3815 0.3989 1.3003 0.0000 0.0120 0.0935 0.3647 0.9758Advertising/Capital 1567 0.3216 0.8444 0.0226 0.0498 0.1219 0.3226 0.6579

Notes:1) Pay-performance sensitivities (PPS) represent incentives provided by direct ownership of stock and stock options for each top

management team or chief executive officer (CEO). They are expressed as percentages of the firm, from 0 to 100.2) Pay-performance sensitivities are calculated from ExecuComp. The standard deviation of monthly returns is based on dollar

returns calculated from CRSP, expressed in millions. All other variables are calculated from Compustat.3) The PPS for the top management team includes the PPS for the CEO plus four times the average PPS for all other executives for

whom data are available.4) All dollar values are in millions of constant 1997 dollars.5) The sample is comprised of 1602 firms observed in any year from 1993 to 1998.

33

Table 2Regressions of Tobin’s Q on Top Management Incentives and Diversification

Variable OLS Fixed Effect OLS w/Controls FE w/ControlsIntercept 2.2090

(0.1719)2.1427

(0.0575)5.2739

(0.8673)5.1538

(1.2811)No. of 4-digit SICs -0.2022

(0.0211)-0.0446(0.0177)

-0.0641(0.0125)

-0.0680(0.0196)

PPS 0.0384(0.0196)

0.0193(0.0041)

0.0288(0.0201)

0.0143(0.0035)

Investment 2.3904(0.4431)

0.9827(0.1768)

Dividend Yield 0.0330(0.0223)

-0.0227(0.0169)

Ln(sales) -0.9811(0.2226)

-0.9344(0.3319)

Ln(sales)2 0.0391(0.0145)

0.0806(0.0227)

Capital/Sales -0.1930(0.0529)

-0.2897(0.0694)

(Capital/Sales)2 -0.0008(0.0025)

0.0047(0.0024)

Cash Flow/Capital 0.0191(0.0215)

0.0729(0.0225)

Debt/Assets -0.8397(0.1645)

-0.9099(0.1753)

Missing D/A 0.7094(0.4301)

-0.6667(0.4954)

CDF of Std Dev 2.6836(0.2119)

-0.9533(0.2812)

Missing Std Dev 1.9313(0.4918)

-0.3441(0.2993)

R & D/Capital -0.0065(0.0632)

0.0418(0.0343)

Missing R&D/K -0.1534(0.0523)

0.0551(0.0904)

Advertising/Capital 0.0956(0.1698)

-0.2123(0.0763)

Missing Adv/K -0.1173(0.0569)

-0.0170(0.0587)

Year = 1994 -0.2382(0.0601)

-0.1837(0.0380)

-0.2223(0.0525)

-0.1786(0.0379)

Year = 1995 -0.1236(0.0622)

-0.0886(0.0371)

-0.0982(0.0540)

-0.0781(0.0413)

Year = 1996 -0.0650(0.0632)

-0.0702(0.0375)

-0.0538(0.0552)

-0.0497(0.0449)

Year = 1997 0.1564(0.0748)

-0.0078(0.0406)

0.1114(0.0664)

0.0254(0.0558)

Year = 1998 0.2976(0.0957)

-0.0166(0.0473)

0.1640(0.0960)

0.0676(0.0527)

R-squared 0.0654 0.8611 0.2322 0.8689Notes:1) Each regression pertains to our sample of 1602 firms and 7045 firm-years.2) The Fixed Effects specification includes a dummy variable for each sample firm.3) Heteroskedasticity-robust standard errors are reported in parentheses beneath each coefficient.

34

Table 3Regressions of Tobin’s Q on CEO Incentives and Diversification

Variable OLS Fixed Effect OLS w/Controls FE w/ControlsIntercept 2.3856

(0.0654)2.2385

(0.0515)5.7443

(0.8573)5.4209

(1.2894)No. of 4-digit SICs -0.2252

(0.0128)-0.0411(0.0177)

-0.0656(0.0116)

-0.0645(0.0196)

PPS 0.0332(0.0091)

0.0115(0.0045)

0.0180(0.0072)

0.0058(0.0043)

Investment 2.4840(0.5156)

1.0061(0.1783)

Dividend Yield 0.0244(0.0150)

-0.0236(0.0173)

Ln(sales) -1.0341(0.2393)

-0.9704(0.3339)

Ln(sales)2 0.0409(0.0150)

0.0818(0.0228)

Capital/Sales -0.2342(0.0363)

-0.3016(0.0698)

(Capital/Sales)2 0.0003(0.0021)

0.0050(0.0024)

Cash Flow/Capital 0.0139(0.0247)

0.0724(0.0229)

Debt/Assets -0.8806(0.1595)

-0.9048(0.1748)

Missing D/A 0.7006(0.4439)

-0.6687(0.4931)

CDF of Std Dev 2.6208(0.1785)

-0.9701(0.2830)

Missing Std Dev 1.9073(0.4933)

-0.3499(0.3028)

R & D/Capital -0.0268(0.0718)

0.0411(0.0347)

Missing R&D/K -0.1170(0.0362)

0.0640(0.0909)

Advertising/Capital 0.1464(0.2041)

-0.2038(0.0771)

Missing Adv/K -0.1316(0.0532)

-0.0159(0.0590)

Year = 1994 -0.2372(0.0596)

-0.1902(0.0385)

-0.2266(0.0518)

-0.1818(0.0381)

Year = 1995 -0.1219(0.0621)

-0.0975(0.0377)

-0.1011(0.0533)

-0.0818(0.0415)

Year = 1996 -0.0683(0.0632)

-0.0827(0.0382)

-0.0593(0.0543)

-0.0547(0.0451)

Year = 1997 0.1537(0.0748)

-0.0240(0.0414)

0.1054(0.0655)

0.0188(0.0560)

Year = 1998 0.3025(0.1025)

-0.0404(0.0486)

0.1642(0.0997)

0.0566(0.0530)

R-squared 0.0415 0.8605 0.2178 0.8685Notes:1) Each regression pertains to our sample of 1602 firms and 7045 firm-years.2) The Fixed Effects specification includes a dummy variable for each sample firm.3) Heteroskedasticity-robust standard errors are reported in parentheses beneath each coefficient.

35

Table 4Regressions of Diversification on Top Management Incentives

Variable OLS Fixed Effect OLS w/Controls FE w/ControlsIntercept 2.0796

(0.0494)1.7676

(0.0271)1.6475

(0.2015)1.6629

(0.3203)PPS -0.0160

(0.0015)0.0050

(0.0018)-0.0014(0.0013)

0.0070(0.0019)

Investment -0.4973(0.1261)

0.0014(0.0879)

Dividend Yield 0.0749(0.0253)

0.0020(0.0045)

Ln(sales) -0.2301(0.0609)

-0.3017(0.1036)

Ln(sales)2 0.0349(0.0046)

0.0488(0.0094)

Capital/Sales -0.0659(0.0329)

-0.1232(0.0451)

(Capital/Sales)2 0.0012(0.0012)

0.0032(0.0013)

Cash Flow/Capital -0.0259(0.0054)

-0.0187(0.0062)

Debt/Assets 0.1424(0.0857)

0.1556(0.0830)

Missing D/A -0.3185(0.1134)

0.1496(0.0868)

CDF of Std Dev -0.2586(0.0777)

-0.4174(0.1186)

Missing Std Dev -0.1024(0.0877)

-0.1919(0.1080)

R & D/Capital -0.0396(0.0122)

-0.0286(0.0156)

Missing R&D/K 0.0334(0.0307)

0.0052(0.0898)

Advertising/Capital 0.1496(0.0339)

0.0466(0.0275)

Missing Adv/K 0.3204(0.0328)

-0.0115(0.0296)

Year = 1994 -0.1191(0.0608)

-0.0123(0.0250)

-0.0929(0.0564)

-0.0278(0.0255)

Year = 1995 -0.1814(0.0594)

-0.0408(0.0240)

-0.1624(0.0560)

-0.0838(0.0267)

Year = 1996 -0.2416(0.0581)

-0.0691(0.0245)

-0.2092(0.0561)

-0.1329(0.0284)

Year = 1997 -0.3232(0.0567)

-0.0850(0.0260)

-0.2479(0.0553)

-0.1719(0.0319)

Year = 1998 -0.1108(0.0571)

0.1261(0.0329)

-0.0333(0.0546)

0.0234(0.0408)

R-squared 0.0270 0.8696 0.1780 0.8749Notes:1) Each regression pertains to our sample of 1602 firms and 7045 firm-years.2) The Fixed Effects specification includes a dummy variable for each sample firm.3) Heteroskedasticity-robust standard errors are reported in parentheses beneath each coefficient.

36

Table 5Regressions of Diversification on CEO Incentives

Variable OLS Fixed Effect OLS w/Controls FE w/ControlsIntercept 2.0508

(0.0489)1.8009

(0.0242)1.6447

(0.2016)1.7632

(0.3187)PPS -0.0208

(0.0018)0.0016

(0.0020)-0.0026(0.0018)

0.0046(0.0020)

Investment -0.4987(0.1262)

0.0115(0.0883)

Dividend Yield 0.0746(0.0252)

0.0014(0.0043)

Ln(sales) -0.2285(0.0610)

-0.3135(0.1037)

Ln(sales)2 0.0347(0.0046)

0.0491(0.0095)

Capital/Sales -0.0659(0.0329)

-0.1279(0.0451)

(Capital/Sales)2 0.0012(0.0012)

0.0034(0.0013)

Cash Flow/Capital -0.0260(0.0054)

-0.0191(0.0061)

Debt/Assets 0.1422(0.0857)

0.1595(0.0831)

Missing D/A -0.3155(0.1136)

0.1488(0.0872)

CDF of Std Dev -0.2573(0.0774)

-0.4227(0.1188)

Missing Std Dev -0.1011(0.0876)

-0.1928(0.1081)

R & D/Capital -0.0397(0.0122)

-0.0289(0.0157)

Missing R&D/K 0.0332(0.0306)

0.0085(0.0898)

Advertising/Capital 0.1494(0.0338)

0.0516(0.0261)

Missing Adv/K 0.3196(0.0329)

-0.0113(0.0296)

Year = 1994 -0.1171(0.0610)

-0.0141(0.0250)

-0.0923(0.0564)

-0.0290(0.0255)

Year = 1995 -0.1815(0.0594)

-0.0436(0.0240)

-0.1621(0.0560)

-0.0853(0.0267)

Year = 1996 -0.2396(0.0582)

-0.0731(0.0243)

-0.2088(0.0560)

-0.1350(0.0283)

Year = 1997 -0.3210(0.0568)

-0.0903(0.0258)

-0.2474(0.0552)

-0.1749(0.0319)

Year = 1998 -0.1112(0.0572)

0.1170(0.0325)

-0.0344(0.0546)

0.0174(0.0407)

R-squared 0.0228 0.8696 0.1779 0.8747Notes:1) Each regression pertains to our sample of 1602 firms and 7045 firm-years.2) The Fixed Effects specification includes a dummy variable for each sample firm.3) Heteroskedasticity-robust standard errors are reported in parentheses beneath each coefficient.

37

Table 6Regressions of Tobin’s Q on Top Mgmt. Incentives Controlling for Changes in Diversification

Variable OLS Fixed Effect OLS w/Controls FE w/ControlsIntercept 2.1609

(0.1765)2.1308

(0.0552)5.2414

(0.8674)5.1524

(1.2796)β1 PPS 0.0410

(0.0208)0.0201

(0.0041)0.0311

(0.0212)0.0150

(0.0036)β2 PPS x ∆ -0.0460

(0.0209)-0.0098(0.0026)

-0.0419(0.0202)

-0.0079(0.0027)

∆ (Change in SICs) -0.0371(0.1148)

-0.0047(0.0337)

-0.0318(0.1062)

-0.0205(0.0317)

No. of 4-digit SICs -0.1866(0.0197)

-0.0422(0.0177)

-0.0512(0.0122)

-0.0645(0.0197)

Investment 2.3743(0.4386)

0.9829(0.1776)

Dividend Yield 0.0328(0.0220)

-0.0228(0.0168)

Ln(sales) -0.9842(0.2219)

-0.9349(0.3316)

Ln(sales)2 0.0391(0.0144)

0.0804(0.0227)

Capital/Sales -0.2019(0.0507)

-0.2926(0.0694)

(Capital/Sales)2 -0.0004(0.0025)

0.0048(0.0024)

Cash Flow/Capital 0.0178(0.0218)

0.0716(0.0226)

Debt/Assets -0.8103(0.1663)

-0.9107(0.1752)

Missing D/A 0.6971(0.4301)

-0.6668(0.4959)

CDF of Std Dev 2.6996(0.2143)

-0.9527(0.2814)

Missing Std Dev 1.9460(0.4935)

-0.3415(0.2998)

R & D/Capital -0.0068(0.0626)

0.0409(0.0342)

Missing R&D/K -0.1414(0.0492)

0.0521(0.0907)

Advertising/Capital 0.1052(0.1726)

-0.2040(0.0761)

Missing Adv/K -0.1121(0.0579)

-0.0137(0.0587)

R-squared 0.0698 0.8612 0.2355 0.8690Coefficient on Incentives (∆=1), p-value in [.]

β1 + β2

H0: = 0-0.0050[0.214]

0.0103[0.019]

-0.0091[0.076]

0.0071[0.090]

Notes:1) Each regression pertains to our sample of 1602 firms and 7045 firm-years.2) The Fixed Effects specification includes a dummy variable for each sample firm.3) Heteroskedasticity-robust standard errors are reported in parentheses beneath each coefficient.4) Year effects are included in all regressions but not reported.5) ∆=1 if No. of 4-digit SICs has changed this year, ∆=0 otherwise.

38

Table 7Regressions of Tobin’s Q on CEO Incentives Controlling for Changes in Diversification

Variable OLS Fixed Effect OLS w/Controls FE w/ControlsIntercept 2.3414

(0.0676)2.2317

(0.0521)5.7221

(0.8551)5.4267

(1.2878)β1 PPS 0.0352

(0.0096)0.0119

(0.0045)0.0194

(0.0076)0.0061

(0.0043)β2 PPS x ∆ -0.0460

(0.0107)-0.0118(0.0047)

-0.0328(0.0096)

-0.0092(0.0047)

∆ (Change in SICs) -0.1644(0.0536)

-0.0387(0.0178)

-0.1569(0.0502)

-0.0276(0.0314)

No. of 4-digit SICs -0.2065(0.0125)

-0.0387(0.0178)

-0.0502(0.0123)

-0.0608(0.0197)

Investment 2.4659(0.5127)

1.0045(0.1789)

Dividend Yield 0.0244(0.0149)

-0.0237(0.0172)

Ln(sales) -1.0386(0.2390)

-0.9712(0.3336)

Ln(sales)2 0.0410(0.0150)

0.0817(0.0228)

Capital/Sales -0.2404(0.0362)

-0.3041(0.0698)

(Capital/Sales)2 0.0005(0.0021)

0.0051(0.0024)

Cash Flow/Capital 0.0134(0.0248)

0.0718(0.0230)

Debt/Assets -0.8612(0.1591)

-0.9082(0.1747)

Missing D/A 0.6892(0.4440)

-0.6692(0.4935)

CDF of Std Dev 2.6326(0.1794)

-0.9702(0.2832)

Missing Std Dev 1.9129(0.4933)

-0.3490(0.3033)

R & D/Capital -0.0265(0.0712)

0.0406(0.0346)

Missing R&D/K -0.1093(0.0359)

0.0614(0.0912)

Advertising/Capital 0.1499(0.2046)

-0.1989(0.0772)

Missing Adv/K -0.1287(0.0532)

-0.0136(0.0590)

R-squared 0.0442 0.8606 0.2195 0.8686Coefficient on Incentives (∆=1), p-value in [.]

β1 + β2

H0: = 0-0.0108[0.017]

0.0001[0.987]

-0.0134[0.016]

-0.0031[0.619]

Notes:1) Each regression pertains to our sample of 1602 firms and 7045 firm-years.2) The Fixed Effects specification includes a dummy variable for each sample firm.3) Heteroskedasticity-robust standard errors are reported in parentheses beneath each coefficient.4) Year effects are included in all regressions but not reported.5) ∆=1 if No. of 4-digit SICs has changed this year, ∆=0 otherwise.