Why Do Firms Diversify? • 87

Second, outsiders will be reluctant to provide capital to firms that have existing debt. This is because new debt and equity are typically junior to the existing debt, which means that existing bondholders have first dibs on any positive cash flows. Third, external finance consumes monitoring resources, for bondand equity holders must ensure that managers take actions that serve their interests.

If external finance is costly, then firms without adequate internal capital may have to forego profitable projects. Thus, firms may benefit by having their own “cash cows” to fund “rising stars” even if they are in unrelated businesses.

The benefits of using an internal capital market may extend to human capital, that is, labor. As John Roberts observes, firms usually have good information about the abilities of their workers, and large diversified firms may have greater opportunities to assign their best workers to the most appropriate and most challenging jobs.18 This may help explain the success of diversified business groups in developing nations, such as Mexico’s Grupo Carso SAB. We say more about these business groups in Chapter 4.

Problematic Justifications for Diversification

Some of the more commonly cited reasons for diversification do not stand up to scrutiny.

Diversifying Shareholders’ Portfolios

Shareholders benefit from investing in a diversified portfolio. By purchasing small holdings in a broad range of firms, investors can reduce the chance of incurring a large loss due to the failure of any single firm and thus insulate themselves from risk. A shareholder seeking to avoid large swings in value might wish to invest in a single diversified firm. But shareholders can diversify their own personal portfolios and seldom need corporate managers to do so on their behalf. Nowadays, investors can choose from countless diversified mutual funds, including some that are invested in thousands of different firms. Diversification to reduce shareholder risk is therefore largely unnecessary.

Identifying Undervalued Firms

Many firms diversify by acquiring established firms in unrelated industries. This can be profitable if the acquirer can identify other firms that are undervalued by the stock market. But how likely is this? This justification requires that the market valuation of the target firm (that is, the firm being purchased) is incorrect and that no other investors have yet identified this fact. Given that speculators, fund managers, and other investors are constantly scouring the market in search of undervalued stocks, it seems hard to believe that a CEO whose attention is largely consumed by running his or her own firm could easily identify valuation errors that these other market participants have missed, unless the target firm is in a closely related business.

Consider also that announcements of merger proposals frequently encourage other potential acquirers to bid for the target firm. Bidding wars reduce the profits an acquiring firm can hope to earn through a merger. Consider Verizon’s February 2005 offer to purchase MCI for $6.75 billion. A rival telecom firm, Qwest, quickly entered the bidding with an even higher offer. After a protracted struggle, with offers and counteroffers going back and forth several times, Verizon purchased MCI for $8.5 billion. It is possible that MCI was a bargain at $6.75 billion, but the $1.75 billion premium Verizon paid may have significantly cut into its profit from the deal.