Discount or Premium? Diversification, Firm Value, and Capital Budgeting Efficiency

Abstract

We model the internal capital market of a conglomerate where headquarters must rely on information reported by division managers to allocate limited resources across competing projects. Managers may exaggerate project quality to attract more capital, which limits the extent of winner-picking in capital budgeting. Focus (correlated projects) helps headquarters to infer information regarding project quality but makes winner-picking less crucial, whereas diversication (distinct projects) facilitates winner-picking but reduces managers’ incentive to report truthfully. We characterize conditions under which diversication improves and destroys rm value, and show that neither allocation eciency nor rm value varies with the degree of