On Eggs and Baskets: An Empirical Study of the Relation between Debt Capacity and Corporate Diversification

Sammanfattning: Economic Theory suggests that corporate diversification has a positive impact on firm debt carrying capacity. The cash flows of a diversified firm's segments result, when imperfectly correlated, in reduced volatility of total cash flows and increased debt carrying capacity. We empirically test the impact of corporate diversification on debt carrying capacity by using an established method based on Standard & Poor's long term credit ratings to estimate debt capacity and the Berry-Herfindahl index to estimate corporate diversification. Using the Compustat database, we measure both industry diversification and geographic diversification. We look at data between 1981-2013 and we study approximately 30,400 firm-year observations. The purpose of this paper is not only to shed a light on the relation between corporate diversification and debt capacity but also to improve current methods of assessing a firm's debt capacity. In our sample, we find strong evidence for a positive association between diversification and debt capacity. Our findings are further confirmed using selected sub-samples.