Abstract:

This paper studies the relation between corporate diversification and cost of capital. It not only examined whether cost of capital is affected by an organizational form (single or multi-segment), but also analyzed under various level of financial constraints and cash flow correlations. Using Indonesian firms database, the finding shows that firm’s cost of capital is positively affected by the level of corporate diversification. The first hypothesis which predicted a negative influence was unsupported by this finding. However, the result of separate regression model shows a dual effect of corporate diversification on cost of debt and cost of equity. While the level of diversification reduces cost of debt, the cost of equity increases siginificantly. As a result, firms that diversify experience a net increase in cost of capital. Another key finding that lower cash flow correlations between business segments correspond to lower cost of capital that support co-insurance hypothesis. The less correlated it is, the greater co-insurance effect would be generated that reduces firm’s cost of capital. The finding support the second hypothesis. In addition, when the sample is divided between financially and unfinancially constrained firms, the results show a significant effect only in financially constrained firms, but in positive direction. It indicates that the influence of diversification on firm’s cost of capital is more pronounced for financially constrained firms which support the third hypothesis.