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Zhenxu Tong

X Centre for Finance and Investment, University of Exeter, Rennes Drive, Exeter EX4 4ST, United Kingdom

a r t i c l e i n f o a b s t r a c t

Article history:

Received 6 February 2008

Received in revised form 3 March 2009

Accepted 5 May 2009

Available online 8 May 2009

This paper studies the effect of rm diversication on the value of corporate cash holdings. We

develop two hypotheses based on efcient internal capital market and agency problems. We

nd that the value of cash is lower in diversied rms than in single-segment rms, and that

rm diversication is associated with a lower value of cash in both nancially unconstrained

and constrained rms. We nd that rm diversication has a negative (zero) impact on the

value of cash among rms with a lower (higher) level of corporate governance. These ndings

are consistent with the interpretation that rm diversication reduces the value of corporate

cash holdings through agency problems.

2009 Elsevier B.V. All rights reserved.

JEL classication:

G32

G34

Keywords:

Firm diversication

Corporate cash holdings

1. Introduction

The impact of rm diversication on rmvalue has received considerable attention from economists. Lang and Stulz (1994) and

Berger and Ofek (1995) nd a signicant diversication discount and interpret the results as evidence of value destruction by

diversied rms. Agency problems have beenproposedas anexplanation for the lower valuations associatedwithrmdiversication.

Denis et al. (1997) nd that agency problems are responsible for rms maintaining value-reducing diversication strategies. Shin and

Stulz (1998) and Rajan et al. (2000) show that the internal capital market in diversied rms engages in cross-subsidization by

allocating too much (too little) to divisions with low (high) investment opportunities. These results are in line with the argument

proposed by Jensen (1986) that managers derive private benets from rm diversication. However, these ndings have been

challengedby a number of other papers. For example, Campa and Kedia (2002) and Grahamet al. (2002) argue that the diversication

discount is tainted by endogeneity problems because rms with poor performance choose to diversify.

1

We contribute to the debate in this literature by studying an under-researched channel through which rm diversication can

affect rm value: corporate cash holdings. The study of corporate cash holdings can complement the existing research in the

following ways.

First, cash holdings provide a promising area to examine the implications of agency problems. Managers can get access to cash

holdings with less scrutiny and use them in a discretionary way. Myers and Rajan (1998) argue that more liquid assets can be

turned into private benets at lower costs. The existing literature has largely focused on investigating investments such as capital

expenditures (e.g., Shin and Stulz, 1998; Rajan et al., 2000) to examine the potential agency problems associated with rm

Journal of Corporate Finance 17 (2011) 741758

I would like to thank David Denis (the Editor), an anonymous referee, and seminar participants at the University of Warwick, the University of Exeter, and the

2008 Financial Management Association European Conference for their comments and suggestions.

Tel.: +44 1392 263155; fax: +44 1392 262475.

E-mail address: z.tong@exeter.ac.uk.

1

The literature has identied other costs or benets associated with rm diversication. For example, Amihud and Lev (1981) argue that there is a managerial

preference for rm diversication to achieve risk reduction. See Stein (2003) and Maksimovic and Phillips (2007) for a more comprehensive review of the

literature.

0929-1199/$ see front matter 2009 Elsevier B.V. All rights reserved.

doi:10.1016/j.jcorpn.2009.05.001

Contents lists available at ScienceDirect

Journal of Corporate Finance

j our nal homepage: www. el sevi er. com/ l ocat e/ j cor pf i n

diversication. Since managers can more easily derive private benets from cash holdings, our study can complement the agency

literature on rm diversication by investigating the value of cash holdings.

Second, cash holdings occupy a signicant role in the balance sheet. Bates et al. (2006) nd that the average cash to asset ratio

for industrial rms increases from10.48% to 24.03% between 1980 and 2004. Moreover, Opler et al. (1999) showthat in their data,

mean corporate cash holdings are greater than mean capital expenditures or mean acquisitions.

2

The magnitude of cash holdings

implies that they serve as a potentially important channel through which rm diversication can affect rm value. The literature

has documented a diversication discount at a magnitude of around 15%, using Tobin's Q as the measure of rmvalue (e.g., Berger

and Ofek, 1995). The calculation of Tobin's Q involves a rm's total assets. It implies that we can study the value impact of

diversication not only through rms' capital expenditures, as often examined in the literature but also through their other types

of assets. Given that the value of cash holdings represents a signicant part of the total rm value, we believe that it is a valid

approach to study the value impact of diversication through corporate cash holdings.

Third, cash holdings are more comparable across rms.

3

One dollar in cash in a diversied rmis physically the same as one dollar

in cash in a single-segment rm. This facilitates the comparison of the value of cash between diversied rms and single-segment

rms. One of the focuses inthe debate over the diversicationdiscount relates tothe comparability of investments betweendiversied

rms and single-segment rms. Since divisional investment opportunities are not directly observable, a method has beenproposed in

the literature to obtain the measures of divisional investment opportunities based on the investment opportunities of single-segment

rms (e.g., Rajan et al., 2000). However, Graham et al. (2002) argue that the discount associated with rm diversication by

acquisitions is not attributable to diversication itself but should be attributed to the fact that diversifying rms acquire assets that are

already valued at a discount relative totheir industry benchmarks. Since cashholdings are more comparable across rms, we candraw

conclusions more directly from the results.

We develop two hypotheses in this paper. First, rm diversication increases the value of cash holdings for nancially

constrained rms through efcient internal capital market because more resources are allocated to the divisions with better

investment opportunities (e.g., Stein, 1997). Second, rm diversication reduces the value of cash holdings through agency

problems because rm diversication can be associated with empire building (e.g., Jensen, 1986) and cross-subsidization (e.g.,

Shin and Stulz, 1998; Rajan et al., 2000).

We use a sample of 28,563 rm-year observations from1998 to 2005. We use the methodology in Faulkender and Wang (2006)

to study the value of corporate cash holdings. We nd that the marginal value of one dollar in diversied (single-segment) rms is

$0.92 ($1.08), implying that the same dollar is valued 16 cents less in diversied rms than single-segment rms. This is consistent

with the interpretation that rm diversication on average reduces the value of cash holdings. We divide the sample into

nancially unconstrained and constrained rms and nd that the value of cash is lower for diversied rms in both sub-samples.

We obtain a measure of corporate governance and divide the sample into the rms with a higher and a lower level of corporate

governance. We nd that rm diversication has a negative (zero) impact on the value of cash among the rms with a lower

(higher) level of corporate governance. We obtain consistent results when we use an alternative measure of unexpected change in

cash holdings, three econometric methods to control for the potential endogeneity problem, an alternative measure of corporate

governance, and pre-1997 data.

These ndings are most consistent with predictions of the agency hypothesis. We conclude that rmdiversication reduces the

value of corporate cash holdings through agency problems.

The remainder of the paper is organized as follows. Section 2 develops two hypotheses about the relation between rm

diversication and the value of cash holdings. Section 3 discusses the data and describes the methodology. Section 4 examines how

rm diversication affects the value of cash holdings. Section 5 concludes the paper.

2. Hypotheses

We develop two hypotheses about the relation between rm diversication and the value of cash holdings in this section.

2.1. Efcient internal capital market

For a given amount of capital, the headquarters of a diversied rm have the control rights to allocate more resources to the

divisions with better investment opportunities. Stein (1997) argues that this form of winner-picking increases the efciency of

internal capital allocation. We expect that among nancially constrained rms, the value of corporate cash holdings is higher for

diversied rms than for single-segment rms. The winner-picking argument is relevant to nancially constrained rms. If a rm

is nancially unconstrained, the rm can receive funding from external capital markets to nance good investment projects. We

thus propose the following hypothesis.

Hypothesis 1. Firm diversication increases the value of cash holdings in nancially constrained rms through efcient internal

capital markets.

2

See Opler et al. (1999), p17. They show that the mean of the ratio Cash/Net Assets (dened as Total Assets minus Cash) is 0.170. The mean of the ratio Capital

Expenditures/Net Assets is 0.090, while the mean of the ratio Acquisitions/Net Assets is 0.011.

3

We follow the literature and use cash and marketable securities (Compustat item #1) to construct the measures of cash holdings. Since rms may hold cash

in the form of marketable securities, we argue that cash holdings are more comparable, rather than identical, across rms.

742 Z. Tong / Journal of Corporate Finance 17 (2011) 741758

2.2. Agency problems

Firmdiversication can be associated with agency problems. At the rmlevel, empire-building preferences will cause managers

to spend available funds excessively on unprotable investment projects (e.g., Jensen, 1986). Morck et al. (1990) nd more negative

market reactions when acquirers are engaging in unrelated diversication. At the segment-level, cross-subsidization can exist in

diversied rms. Cross-subsidization refers to the diversion of corporate resources from divisions with good investment

opportunities to divisions with poor investment opportunities. Shin and Stulz (1998) and Rajan et al. (2000) nd evidence of

inefcient cross-subsidization in diversied rms. Correspondingly, Ahn and Denis (2004) nd that corporate spinoffs result in a

signicant increase in investment efciency and create value by breaking up the conglomerates. Because cash holdings are more

liquid assets, managers can use cash in a discretionary way and thus derive private benets more easily. We expect that agency

problems reduce the value of cash holdings in a diversied rm because shareholders anticipate the inefcient use of cash. We

propose the following hypothesis.

Hypothesis 2. Firm diversication reduces the value of cash holdings through agency problems.

2.3. Combining the hypotheses

We combine the above two hypotheses into the following table.

The impact of rm diversication on the value of cash

Efcient internal capital market Agency problems

Financially unconstrained rms 0

Financially constrained rms +

This table summarizes the predictions of the two hypotheses. A plus (minus) sign indicates a positive (negative) impact of rm

diversication on the value of cash holdings. A zero sign indicates no relation between these two. The predictions of the two

hypotheses are different.

We supplement the analysis by comparing the marginal value of $1 with one. From the perspective of agency problems, we

expect that an additional dollar is valued signicantly less than one in diversied rms because of the anticipated misallocation of

cash by managers.

4

3. Data and methodology

In this section, we describe the data and the methodology.

3.1. Data

We obtain segment-level data fromthe Compustat/Segment database. We use the Compustat/Industrial Annual database as the

source for the rm-level data. We obtain stock return data from CRSP. The sample period is from 1998 to 2005. The Statement of

Financial Accounting Standards (SFAS) No. 131 was issued as a new standard for the reporting of segment information in 1997.

Villalonga (2004a,b) and Berger and Hann (2003) show that segment data before and after 1997 are not directly comparable to

each other. Since we use the 2006 version of Compustat, we set the sample period from1998 to 2005, using the data in the period

after the implementation of SFAS 131 to ensure the comparability of the data.

5

We match the Compustat/Segment with the Compustat/Industrial Annual and CRSP databases and exclude rms with

incomplete data. Following the literature on rm diversication (e.g., Berger and Ofek, 1995), we exclude nancial service rms

and rms with nancial service segments (SIC codes between 6000 and 6999). We also require that the sum of the segment sales

be within 1% of the total sales of the rm. We dene diversied rms as the rms that have at least two segments with different SIC

codes.

6

The observations of multi-segment rms with segments in the same SIC codes are treated as single-segment rms. After

these screening procedures, we obtain a nal sample of 6867 rms with 28,563 rm-year observations. The sample contains

10,828 (17,735) rm-year observations for diversied (single-segment) rms.

4

An alternative argument predicts a lower value of cash in diversied rms because diversied rms have marginally fewer protable investment

opportunities than single-segment rms. In this case, we still expect that the marginal value of $1 is not less than one in diversied rms because there is no

waste of cash by managers under this argument.

5

We use pre-1997 data for robustness checks in the later analysis.

6

We obtain similar results by dening diversied rms as the rms that have at least two segments with different two-digit SIC codes.

743 Z. Tong / Journal of Corporate Finance 17 (2011) 741758

3.2. Methodology

Faulkender and Wang (2006) developed a methodology to measure the marginal value of cash holdings. We follow their

method and develop the primary specication as follows.

R

i;t

RB

i;t

= a + b

1

CashHoldings

i;t

MV

i;t 1

+ b

2

FirmDiversification

i;t

CashHoldings

i;t

MV

i;t 1

+ b

3

FirmDiversification

i;t

+ b

4

Earnings

i;t

MV

i;t 1

+ b

5

Net Assets

i;t

MV

i;t 1

+ b

6

R&D

i;t

MV

i;t 1

+ b

7

Interest Expenses

i;t

MV

i;t 1

+ b

8

Dividends

i;t

MV

i;t 1

+ b

9

CashHoldings

i;t 1

+ b

10

Leverage

i;t

+ b

11

CashHoldings

i;t 1

CashHoldings

i;t

MV

i;t 1

+ b

12

Leverage

i;t

CashHoldings

i;t

MV

i;t 1

+ b

13

New Financing

i;t

MV

i;t 1

+ e

i;t

;

1

where X

i,t

indicates the change in the variable X of rm i from year t 1 to t.

(e.g., Cash holdings

i,t

=cash holdings

i,t

cash holdings

i, t 1

)

R

i,t

: stock return over scal year t 1 to t.

RB

i,t

: stock i's benchmark return over scal year t 1 to t. The benchmark portfolio is one of the 25 Fama and French portfolios

formed on size and book-to-market.

MV

i,t 1

: market value of equity at year t 1 computed as price times shares outstanding.

Firm Diversication

i,t

: a dummy variable that equals 1 for diversied rms and 0 for single-segment rms.

Cash Holdings

i,t

: cash and marketable securities at year t.

Earnings

i,t

: earnings before extraordinary items over scal year t 1 to t.

Net Assets

i,t

: net assets (total assetscash holdings) at year t.

R&D

i,t

: R&D expenses over scal year t 1 to t.

Interest Expenses

i,t

: interest expenses over scal year t 1 to t.

Dividends

i,t

: common dividends over scal year t 1 to t.

Leverage

i,t

: leverage (debt / total assets) at year t.

New Financing

i,t

: net new equity issues (equity issued minus repurchases)+net new debt issues (debt issued minus debt

retired) over scal year t 1 to t.

This methodology essentially represents a long-run event study. The event is the unexpected change in cash holdings, while the

event windowis dened as the entire scal year. In the above equation, the dependent variable is excess stock return. It is calculated

as the stock return of rmi during a scal year t (R

i,t

), minus its benchmark return over the same period (RB

i,t

). This left-hand side

variable is interpreted as the cumulative abnormal return during a scal year, which incorporates the market reaction to the

unexpected change in corporate cash holdings. We use the 25 Fama and French portfolios formed on size and book-to-market as

benchmark portfolios. For each rm-year observation, a rmis grouped into one of the 25 Fama and French portfolios based on the

intersection between size and book-to-market. The return of the corresponding Fama and French portfolio is regarded as the

benchmark return for the rm during that year.

We rst dene the unexpected change in cash holdings as the realized change in cash holdings. Then we use an alternative

measure based on the net change in cash holdings. In the primary specication, we measure the change in cash holdings as the

ratio of the change in cash and marketable securities (Compustat item#1) over the scal year to the 1-year lagged market value of

equity. Since both the dependent variable and the independent variable are scaled by the 1-year lagged market value of equity, the

coefcient represents the dollar change in shareholder value resulting froma one-dollar change in the amount of cash held by the

rm. We can interpret this as the marginal value of one dollar to the shareholders of the rm.

We construct an interaction term, Firm DiversicationCash Holdings. Firm Diversication is a dummy variable that equals 1

for diversied rms and 0 for single-segment rms. The coefcient of this interaction term represents the difference in the

marginal value of one dollar between diversied rms and single-segment rms, thus indicating the impact of rm diversication

on the value of cash holdings. We also include the Firm Diversication dummy in the regression to ensure that the estimated

coefcient of the interaction term is due to the interaction, and not due to rm diversication itself.

We include other control variables in the regression, as suggested by Faulkender and Wang (2006). They argue that the value of

cash holdings depends on both leverage and the lag of cash holdings, and they include the interaction terms between these two

variables and the change in cash holdings in the regression. We control for sources of value other than cash (Earnings, Net Assets,

R&D, Interest Expenses, Dividends, and New Financing). We provide more details on the denition of the variables in the

Appendix A. We winsorize the data at 1% and 99% to reduce the impact of outliers.

744 Z. Tong / Journal of Corporate Finance 17 (2011) 741758

4. Results

We report the results in this section. We rst present the relation between rm diversication and the value of cash holdings

in the entire sample. Then we demonstrate the results by dividing the sample into nancially unconstrained rms and

constrained rms. We next investigate the impact of corporate governance on the value of cash between diversied rms and

single-segment rms. Finally, we report the results using an alternative measure of unexpected changes in cash holdings, three

econometric methods to control for the potential endogeneity problem, an alternative measure of corporate governance, and

pre-1997 data. In the regressions, we report the p-value calculated based on the robustness standard errors clustered by rm

(e.g., Petersen, 2009).

4.1. The value of cash holdings

Our primary objective is to measure the impact of rmdiversication on the value of cash holdings. The results are presented in

Table 1. We rst examine the marginal value of cash holdings in the entire sample and report the results in the rst and second

columns. In this regression, an extra dollar in cash will affect a rm's excess return through the item Cash Holdings and the

interaction terms (Cash Holding

t 1

Cash Holdings and LeverageCash Holdings). We use the coefcients of these items to

obtain the marginal value. The calculation is as follows: the mean rmhas a lag of cash holdings equivalent to 16.56% of the market

capitalization of equity, and the mean leverage ratio is 20.14%. Therefore, the marginal value of one dollar to shareholders in the

mean rm is $1.02 (=1.245+(0.72616.56%)+(0.50920.14%)). We conduct the F-test on the null hypothesis that the

marginal value of $1 is one and report the p-value in the brackets. We nd that an additional dollar is valued insignicantly

different from one (p-value=0.43) in the entire sample.

In the third and fourth columns of Table 1, we report the impact of rmdiversication on the value of corporate cash holdings. This

regressionfollows the primary specication, as indicatedinEq. (1). To calculate the marginal value of cashholdings for single-segment

rms, we need to use the coefcients of the same three items as before (Cash Holdings, Cash Holding

t 1

Cash Holdings, and

LeverageCash Holdings). We nd that the marginal value of one dollar to shareholders in single-segment rms is $1.08. The F-test

shows that it is signicantly different fromone (p-value=0.02). To calculate the marginal value of cash holdings for diversied rms,

we need to use the coefcient of the interactiontermFirmDiversicationCashHoldings. Therefore, the marginal value of one dollar

to shareholders in diversied rms is $0.92 (=1.295+(0.160)+(0.74116.56%)+(0.47820.14%)). The F-test shows that it is

signicantly different from one (p-value=0.04).

Table 1

The value of cash holdings.

Coef. p-value Coef. p-value

Intercept 0.003 0.61 0.003 0.64

Cash Holdings 1.245 0.01 1.295 0.01

Firm DiversicationCash Holdings 0.160 0.01

Firm Diversication 0.001 0.98

Earnings 0.649 0.01 0.648 0.01

Net Assets 0.284 0.01 0.284 0.01

R&D 0.742 0.01 0.744 0.01

Interest Expenses 1.305 0.01 1.309 0.01

Dividends 2.814 0.01 2.821 0.01

Cash Holdings

t 1

0.194 0.01 0.195 0.01

Leverage 0.224 0.01 0.223 0.01

Cash Holdings

t 1

Cash Holdings 0.726 0.01 0.741 0.01

LeverageCash Holdings 0.509 0.01 0.478 0.01

New Financing 0.011 0.69 0.007 0.78

Observations 28,563 28,563

Adjusted R

2

0.13 0.14

The following table shows the marginal value of $1, calculated based on the estimates in the regressions (see text for more details). We conduct the F-test on the

null hypothesis that the marginal value of $1 is one, and we report the p-value in the brackets.

The marginal value of $1

Entire sample $1.02 (0.43) Single-segment rms $1.08 (0.02)

Diversied rms $0.92 (0.04)

This table reports the value of cash holdings. The dependent variable is Excess Return, dened as R

i,t

RB

i,t

. All variables except Excess Return, FirmDiversication, and

Leverage are standardized by the lagged market value of equity. Cash Holdings is cash plus marketable securities. Cash Holdings is the one-year change in cash holdings

(CashHoldings

t

CashHoldings

t 1

). FirmDiversicationis a dummyvariablethat equals 1for diversiedrms and0for single-segment rms. Earnings is theone-year

change in earnings before extraordinary items. Net Assets is the one-year change in total assets minus cash holdings. R&D is the one-year change in research and

development expenses. Interest Expenses is the one-year change in interest expenses. Dividends is the one-year change in common dividends. Leverage is the ratio

of debt to total assets. New Financing is net new equity issues plus net new debt issues. The p-value is calculated based on robust standard errors.

745 Z. Tong / Journal of Corporate Finance 17 (2011) 741758

These results indicate that an extra dollar in diversied rms on average is valued 16 cents (p-value=0.01) less than an extra

dollar in single-segment rms. It implies that rm diversication reduces the value of cash holdings. Moreover, since the marginal

value of $1 is signicantly belowone in diversied rms, this is consistent with the agency hypothesis and reects the anticipated

misallocation of cash by the managers in diversied rms.

4.2. Financial constraints

We proceed to conduct the tests by dividing the sample into nancially unconstrained and constrained rms. We design two

criteria for nancial constraints based on the measures used in the previous literature (e.g., Almeida et al., 2004). We use the

lagged variables to measure the criteria. Since lagged variables are pre-determined, they are less likely to be subject to the

endogeneity problem.

4.2.1. The criteria of nancial constraints

4.2.1.1. Payout. Fazzari et al. (1988) state that nancially constrained rms have lower payout ratios. Firms with higher payout

ratios are more likely to have sufcient internal resources to nance their investments. We use the ratio of the sum of dividends

and stock repurchases to total assets as the measure for the payout ratio. For every year of the sample period, we sort all rms

according to their payout ratios at year t 1 and assign a rm to the nancially unconstrained (constrained) group if its lagged

payout ratio is above (below) the mean of the annual payout distribution.

4.2.1.2. Credit rating. Firms with a credit rating have better access to public debt markets. They are usually better known and have

less difculty in raising external funds to nance their investments. For every rm-year observation, we obtain data for long-term

issuer credit ratings at year t 1 from Compustat, and we assign a rm to the nancially unconstrained (constrained) group if its

lagged long-term issuer credit rating is available (unavailable).

4.2.2. Results

Table 2 presents the results by dividing the sample into nancially unconstrained and constrained rms according to the two

criteria, and it reports the marginal value of cash below the regressions. We show the results using payout as the nancial

constraints criterion in Panel A. We nd that the coefcients of the interaction term, Firm DiversicationCash Holdings, are

negative and signicant, supporting the interpretation that rm diversication reduces the value of cash holdings in both

nancially unconstrained rms and constrained rms.

Among nancially unconstrained rms, we nd that an additional dollar is valued at $1.01, which is insignicantly different

from one (p-value=0.88), in single-segment rms. We also nd that an additional dollar is valued at $0.83, which is signicantly

different from one (p-value=0.06), in diversied rms. The results imply that shareholders place a lower value on the cash

holdings in diversied rms because of the anticipated inefcient use of cash. This is consistent with the predictions of the agency

hypothesis.

Among nancially constrained rms, we nd that an additional dollar is valued at $1.12, which is signicantly different

fromone (p-value=0.01), in single-segment rms. Although the interaction term, FirmDiversicationCash Holdings, is 0.151

(p-value=0.01), we nd that an additional dollar is valued at $0.96, which is insignicantly different fromone (p-value=0.27), in

diversied rms. We report the results using credit rating as the criterion for nancial constraints in Panel B and nd a consistent

pattern.

The interpretation of the results for nancially constrained rms is confounded by the fact that corporate governance and

nancial constraints can concurrently affect the value of cash holdings (e.g., Dittmar and Mahrt-Smith, 2007).

7

Faulkender and

Wang (2006) nd that the difference in the value of an additional dollar between nancially unconstrained rms and constrained

rms can reach up to $0.63.

8

This economic magnitude is consistent with the ndings in Denis and Sibilkov (2009) who document

that the marginal value of cash can be 51 cents higher in constrained rms than in unconstrained rms. These ndings in the

literature imply that it is possible to discover a situation where the negative impact of agency problems and the positive impact of

nancial constraints on the value of cash offset each other, so that we observe a marginal value of cash insignicantly different from

one for nancially constrained rms. Therefore, we conduct further analysis aiming to identify whether agency problems also

prevail in the value of cash holdings for diversied rms among nancially constrained rms.

4.3. Corporate governance

We include a measure of corporate governance in this section and more explicitly examine the impact of agency problems on

the value of cash holdings in diversied rms. From the agency perspective, we expect a negative (zero) impact of diversication

7

See Dittmar and Mahrt-Smith (2007), p612614.

8

See Faulkender and Wang (2006), p1981.

746 Z. Tong / Journal of Corporate Finance 17 (2011) 741758

Table 2

Regressions for nancially unconstrained and constrained rms.

Panel A. The criteria for nancial constraints: payout

Unconstrained Constrained

Coef. p-value Coef. p-value

Intercept 0.045 0.18 0.030 0.01

Cash Holdings 1.202 0.01 1.351 0.01

Firm DiversicationCash Holdings 0.185 0.06 0.151 0.01

Firm Diversication 0.004 0.70 0.001 0.89

Earnings 0.775 0.01 0.632 0.01

Net Assets 0.296 0.01 0.308 0.01

R&D 1.144 0.01 0.692 0.01

Interest Expenses 2.838 0.01 1.677 0.01

Dividends 3.459 0.01 4.026 0.01

Cash Holdings

t 1

0.140 0.08 0.251 0.01

Leverage 0.037 0.48 0.139 0.01

Cash Holdings

t 1

Cash Holdings 0.202 0.05 0.819 0.01

LeverageCash Holdings 1.130 0.33 0.698 0.01

New Financing 0.278 0.01 0.034 0.25

Observations 7011 21,552

Adjusted R

2

0.11 0.14

The following table shows the marginal value of $1, calculated based on the estimates in the regressions. We conduct the F-test on the null hypothesis that the

marginal value of $1 is one, and we report the p-value in the brackets.

The marginal value of $1

Unconstrained Constrained

Single-segment rms $1.01 (0.88) $1.12 (0.01)

Diversied rms $0.83 (0.06) $0.96 (0.27)

Panel B. The criteria for nancial constraints: credit rating

Unconstrained Constrained

Coef. p-value Coef. p-value

Intercept 0.023 0.37 0.090 0.01

Cash Holdings 1.190 0.01 1.462 0.01

Firm DiversicationCash Holdings 0.198 0.03 0.143 0.02

Firm Diversication 0.041 0.03 0.013 0.18

Earnings 0.905 0.01 0.654 0.01

Net Assets 0.219 0.04 0.370 0.01

R&D 0.152 0.87 0.819 0.01

Interest Expenses 1.665 0.01 1.968 0.01

Dividends 4.314 0.01 3.555 0.01

Cash Holdings

t 1

0.295 0.01 0.331 0.01

Leverage 0.084 0.22 0.145 0.01

Cash Holdings

t 1

Cash Holdings 0.774 0.01 1.672 0.01

LeverageCash Holdings 0.295 0.11 0.446 0.01

New Financing 0.147 0.11 0.009 0.77

Observations 6052 22,511

Adjusted R

2

0.13 0.13

The following table shows the marginal value of $1, calculated based on the estimates in the regressions. We conduct the F-test on the null hypothesis that the

marginal value of $1 is one, and we report the p-value in the brackets.

The marginal value of $1

Unconstrained Constrained

Single-segment rms $1.02 (0.85) $1.11 (0.01)

Diversied rms $0.82 (0.05) $0.97 (0.54)

This table reports results using the criteria of nancial constraints. The regressions are presented across the groups of nancially unconstrained and constrained

rms (see text for denitions). The criteria for nancial constraints are payout (Panel A) and credit rating (Panel B). The dependent variable is Excess Return, dened

as R

i,t

RB

i,t

. All variables except Excess Return, Firm Diversication, and Leverage are standardized by the lagged market value of equity. Cash Holdings is cash plus

marketable securities. Cash Holdings is the one-year change in cash holdings (Cash Holdings

t

Cash Holdings

t 1

). Firm Diversication is a dummy variable that

equals 1 for diversied rms and 0 for single-segment rms. Earnings is the one-year change in earnings before extraordinary items. Net Assets is the one-year

change of total assets minus cash holdings. R&D is the one-year change of research and development expenses. Interest Expenses is the one-year change in

interest expenses. Dividends is the one-year change in common dividends. Leverage is the ratio of debt to total assets. New Financing is net new equity issues

plus net new debt issues. The p-value is calculated based on robust standard errors.

747 Z. Tong / Journal of Corporate Finance 17 (2011) 741758

on the value of cash among the rms with a lower (higher) level of corporate governance.

9

We use a corporate governance index

(Gindex) proposed by Gompers et al. (2003). We use the data on corporate charters of takeover defenses from the Investor

Responsibility Research Center (IRRC) database. A higher Gompers et al. index indicates more restrictions on shareholder rights,

thus corresponding to a lower level of corporate governance.

10

The IRRC database only provides the data for a subset of rms

(mostly larger rms) in the sample. We conduct the analysis with this sub-sample that contains 8242 rm-year observations.

We divide the sample into two groups. One group has a higher level of corporate governance (Gindexb7) and includes

observations in the bottom quartile. The other group has a lower level of corporate governance (Gindex7). We separately

estimate the regressions for each group and report the results in Table 3. We nd that the coefcient of the interaction term, Firm

DiversicationCash Holdings, is 0.064 (p-value=0.90) in the group with a higher level of corporate governance. This is

consistent with the interpretation that since good corporate governance alleviates agency problems in diversied rms, we do not

nd a signicant difference in the value of cash between diversied rms and single-segment rms. Correspondingly, we nd that

the marginal value of one dollar is $1.25 ($1.19) in diversied (single-segment) rms. This implies that cash holdings are valuable

to the shareholders in both diversied rms and single-segment rms with a higher level of corporate governance.

However, we nd that the coefcient of the interaction term, Firm DiversicationCash Holdings, is still negative and

signicant in the group with a lower level of corporate governance. Correspondingly, we nd that the marginal value of one dollar

is $0.49 ($0.88) in diversied (single-segment) rms. Both are signicantly different from one. This supports the interpretation

that shareholders place a lower value on cash holdings in rms with lower levels of corporate governance, and that cash is even

less valuable in diversied rms because of the additional agency problems associated with rm diversication. We conduct a

9

A higher level of corporate governance wipes out the difference in the value of cash between diversied rms and single-segment rms caused by agency

problems. We thank an anonymous referee for comments on this point.

10

The Gompers et al. index has a range of possible values from 0 to 24. See Gompers et al. (2003) for more details.

Table 3

The Impact of corporate governance.

Higher governance Lower governance

Gindexb7 (bottom quartile) Gindex7

Coef. p-value Coef. p-value

Intercept 0.050 0.16 0.033 0.04

Cash Holdings 1.515 0.01 1.158 0.01

Firm DiversicationCash Holdings 0.064 0.90 0.389 0.05

Firm Diversication 0.040 0.27 0.016 0.20

Earnings 0.798 0.01 0.715 0.01

Net Assets 0.351 0.01 0.375 0.01

R&D 0.593 0.64 0.709 0.19

Interest Expenses 1.379 0.27 3.280 0.01

Dividends 5.273 0.10 4.442 0.01

Cash Holdings

t 1

0.161 0.26 0.160 0.01

Leverage 0.103 0.34 0.131 0.01

Cash Holdings

t 1

Cash Holdings 1.758 0.01 0.680 0.39

LeverageCash Holdings 0.650 0.22 1.042 0.04

New Financing 0.330 0.18 0.331 0.01

Observations 1608 6634

Adjusted R

2

0.09 0.14

The following table shows the marginal value of $1, calculated based on the estimates in the regressions. We conduct the F-test on the null hypothesis that the

marginal value of $1 is one, and we report the p-value in the brackets.

The marginal value of $1

Higher governance Lower governance

Gindexb7 (bottom quartile) Gindex7

Single-segment rms $1.19 (0.06) $0.88 (0.07)

Diversied rms $1.25 (0.01) $0.49 (0.01)

The following table shows the difference in the effect of diversication on the value of cash between high and lowgovernance rms and reports the p-value of the

t-test in the brackets.

Difference 0.453 (0.01)

This table reports the impact of corporate governance. The dependent variable is Excess Return, dened as R

i,t

RB

i,t

. All variables except Excess Return, Firm

Diversication, and Leverage are standardized by the lagged market value of equity. Gindex is the corporate governance index constructed by Gompers et al.

(2003). Cash Holdings is cash plus marketable securities. Cash Holdings is the one-year change in cash holdings (Cash Holdings

t

Cash Holdings

t 1

).

Earnings is the one-year change in earnings before extraordinary items. Net Assets is the one-year change in total assets minus cash holdings. R&D is the one-

year change in research and development expenses. Interest Expenses is the one-year change in interest expenses. Dividends is the one-year change in

common dividends. Leverage is the ratio of debt to total assets. New Financing is net new equity issues plus net new debt issues. The p-value is calculated based

on robust standard errors.

748 Z. Tong / Journal of Corporate Finance 17 (2011) 741758

t-test of the difference in the effect of diversication on the value of cash between high and lowgovernance rms. We discover

that the difference is signicant (p-value=0.01). Therefore, the results in Table 3 are consistent with the agency hypothesis.

4.4. Financial constraints and corporate governance

We examine the effect of diversication on the value of cash for high and low governance rms separately for unconstrained

and constrained rms in this section. This can conrm whether the value of cash is affected by agency problems in both

unconstrained and constrained rms. We divide the sub-sample covered by the IRRC database into four groups and estimate the

value of cash for each group.

We report the results in Table 4. Among nancially unconstrained rms with a higher level of corporate governance, we nd

that an additional dollar is valued at $1.04 (p-value=0.59) in single-segment rms. We also nd that an additional dollar is valued

at $1.03 (p-value=0.72) in diversied rms. The coefcient of the interaction term, Firm Diversication Cash Holdings, is

0.006 (p-value=0.98). Among nancially unconstrained rms with a lower level of corporate governance, we nd that an

additional dollar is worth $0.83 (p-value=0.05) in single-segment rms, while it is worth $0.46 (p-value=0.01) in diversied

rms. The coefcient of the interaction term, FirmDiversication Cash Holdings, is 0.371 (p-value=0.03). The t-test shows a

signicant difference (p-value=0.04) between high and lowgovernance rms in the effect of diversication on the value of cash.

Therefore, the results are consistent with the interpretation that rm diversication has a negative (zero) impact on the value of

cash among rms with a lower (higher) level of corporate governance for nancially unconstrained rms.

Table 4

Financial constraints and corporate governance.

Unconstrained Constrained

Higher governance Lower governance Higher governance Lower governance

Gindexb7

(bottom quartile)

Gindex7 Gindexb7

(bottom quartile)

Gindex7

Coef. p-value Coef. p-value Coef. p-value Coef. p-value

Intercept 0.019 0.58 0.026 0.18 0.037 0.45 0.046 0.05

Cash Holdings 1.427 0.01 1.118 0.01 1.771 0.05 1.256 0.01

Firm DiversicationCash Holdings 0.006 0.98 0.371 0.03 0.034 0.96 0.309 0.06

Firm Diversication 0.067 0.05 0.035 0.02 0.027 0.59 0.018 0.38

Earnings 0.637 0.01 1.063 0.01 0.867 0.01 0.744 0.01

Net Assets 0.445 0.01 0.324 0.01 0.320 0.03 0.336 0.01

R&D 0.754 0.73 0.337 0.49 0.610 0.70 1.216 0.10

Interest Expenses 3.391 0.02 4.577 0.01 1.365 0.33 3.186 0.01

Dividends 2.317 0.47 3.128 0.03 7.774 0.17 7.028 0.01

Cash Holdings

t 1

0.131 0.34 0.023 0.79 0.270 0.17 0.187 0.01

Leverage 0.118 0.39 0.104 0.11 0.102 0.47 0.103 0.11

Cash Holdings

t 1

Cash Holdings 0.408 0.85 2.294 0.03 2.168 0.03 0.298 0.75

LeverageCash Holdings 1.727 0.02 0.117 0.93 0.233 0.89 1.252 0.01

New Financing 0.362 0.12 0.274 0.01 0.299 0.29 0.237 0.03

Observations 518 2860 1090 3774

Adjusted R

2

0.19 0.14 0.09 0.15

The following table shows the marginal value of $1, calculated based on the estimates in the regressions. We conduct the F-test on the null hypothesis that the

marginal value of $1 is one, and we report the p-value in the brackets.

The marginal value of $1

Unconstrained Constrained

Higher governance Lower governance Higher governance Lower governance

Gindexb7 (bottom quartile) Gindex7 Gindexb7 (bottom quartile) Gindex7

Single-segment rms 1.04 (0.59) 0.83 (0.05) 1.48 (0.03) 0.98 (0.79)

Diversied rms 1.03 (0.72) 0.46 (0.01) 1.45 (0.03) 0.67 (0.05)

The following table shows the difference in the effect of diversication on the value of cash between high and lowgovernance rms and reports the p-value of the

t-test in the brackets.

Unconstrained Constrained

Difference 0.365 (0.04) 0.275 (0.07)

This table reports the results using the criteria of both nancial constraints and corporate governance. The regressions are presented across the groups of nancially

unconstrained/constrained rms and high/low governance rms. Payout is the criterion for nancial constraints. Gindex is the corporate governance index constructed

by Gompers et al. (2003). The dependent variable is Excess Return, dened as R

i,t

RB

i,t

. All variables except Excess Return, Firm Diversication, and Leverage are

standardized by the lagged market value of equity. Cash Holdings is cash plus marketable securities. Cash Holdings is the one-year change in cash holdings

(Cash Holdings

t

Cash Holdings

t 1

). Firm Diversication is a dummy variable that equals 1 for diversied rms and 0 for single-segment rms. Earnings is the

one-year change in earnings before extraordinary items. Net Assets is the one-year change in total assets minus cash holdings. R&D is the one-year change

in research and development expenses. Interest Expenses is the one-year change in interest expenses. Dividends is the one-year change in common dividends.

Leverage is the ratio of debt to total assets. New Financing is net new equity issues plus net new debt issues. The p-value is calculated based on robust standard errors.

749 Z. Tong / Journal of Corporate Finance 17 (2011) 741758

Among nancially constrained rms with a higher level of corporate governance, we nd that an additional dollar is valued at

$1.48 (p-value=0.03) in single-segment rms. We also nd that an additional dollar is valued at $1.45 (p-value=0.03) in

diversied rms. The coefcient of the interaction term, Firm Diversication Cash Holdings, is 0.034 (p-value=0.96).

Among nancially constrained rms with a lower level of corporate governance, we nd that an additional dollar is worth $0.98

(p-value=0.79) in single-segment rms, while it is worth $0.67 (p-value=0.05) in diversied rms. The coefcient of the

interaction term, Firm Diversication Cash Holdings, is 0.309 (p-value=0.06). The t-test shows a signicant difference (p-

value=0.07) between high and low governance rms in the effect of diversication on the value of cash. These results reconcile

the agency hypothesis and the ndings in Table 2 that the marginal value of $1 is insignicantly different from one for diversied

rms among nancially constrained rms. When we divide constrained rms into two groups depending on their levels of

corporate governance, we nd that agency problems also prevail in the value of cash holdings for diversied rms among

nancially constrained rms with a lower level of corporate governance. Therefore, these ndings are consistent with the agency

hypothesis.

4.5. Alternative measure of the unexpected change in cash holdings

Our primary specication essentially represents a long-term event study. The excess return reects the market reaction to

unexpected changes in cash holdings. We followFaulkender and Wang (2006) and repeat our analysis using the net change in cash

holdings dened as the realized change in cash holdings minus the average change in cash holdings in the corresponding

benchmark portfolio over the same period. There is an additional advantage to using the net change in cash holdings. Bates et al.

(2006) document a time trend in the level of cash holdings. We expect the time trend to be present in both a rm's realized change

in cash holdings and the average change in cash holdings in the corresponding benchmark portfolio. We can therefore reduce the

impact of the time trend by using the net change in cash holdings.

Table 5A shows that an extra dollar is worth $1.08 ($0.93) for single-segment (diversied) rms. We repeat the analysis on the

marginal value of cash for nancially unconstrained rms and constrained rms and report the results in this table, using payout as

the criterion for nancial constraints. We obtain consistent results using credit rating as the criterion for nancial constraints. The

results are similar to those presented above. Firm diversication reduces the value of cash holdings in both nancially

Table 5A

The value of cash holdings alternative measure of the unexpected change in cash holdings.

Entire Sample Unconstrained Constrained

Coef. p-value Coef. p-value Coef. p-value

Intercept 0.016 0.01 0.016 0.55 0.065 0.01

Net Cash Holdings 1.394 0.01 1.113 0.01 1.482 0.01

Firm DiversicationNet Cash Holdings 0.155 0.01 0.169 0.02 0.180 0.01

Firm Diversication 0.001 0.97 0.006 0.37 0.010 0.19

Earnings 0.652 0.01 0.777 0.01 0.681 0.01

Net Assets 0.291 0.01 0.260 0.01 0.349 0.01

R&D 0.698 0.01 1.149 0.03 0.863 0.01

Interest Expenses 1.427 0.01 2.314 0.01 1.522 0.01

Dividends 2.926 0.01 2.679 0.01 3.864 0.01

Cash Holdings

t 1

0.250 0.01 0.128 0.14 0.286 0.01

Leverage 0.147 0.01 0.079 0.12 0.135 0.01

Cash Holdings

t 1

Net Cash Holdings 1.211 0.01 0.778 0.02 1.268 0.01

LeverageNet Cash Holdings 0.706 0.01 0.162 0.57 0.718 0.01

New Financing 0.025 0.34 0.175 0.04 0.059 0.07

Observations 28,563 7011 21,552

Adjusted R

2

0.13 0.12 0.13

The following table shows the marginal value of $1, calculated based on the estimates in the regressions. We conduct the F-test on the null hypothesis that the

marginal value of $1 is one, and we report the p-value in the brackets.

The marginal value of $1

Entire sample Unconstrained Constrained

Single-segment rms $1.08 (0.03) $1.02 (0.92) $1.15 (0.01)

Diversied rms $0.93 (0.02) $0.87 (0.08) $0.97 (0.53)

This table reports the value of cash holdings using an alternative measure of the unexpected change in cash holdings. Payout is the criterion for nancial

constraints. The dependent variable is Excess Return, dened as R

i,t

RB

i,t

. All variables except Excess Return, Firm Diversication, and Leverage are standardized

by the lagged market value of equity. Cash Holdings is cash plus marketable securities. Net Cash Holdings is the realized change in cash holdings minus the

average change in cash holdings in the corresponding benchmark portfolio over the same period (see text for more details). Firm Diversication is a dummy

variable that equals 1 for diversied rms and 0 for single-segment rms. Earnings is the one-year change in earnings before extraordinary items (Earnings

t

Earnings

t 1

). Net Assets is the one-year change in total assets minus cash holdings. R&D is the one-year change in research and development expenses.

Interest Expenses is the one-year change in interest expenses. Dividends is the one-year change in common dividends. Leverage is the ratio of debt to total

assets. New Financing is net new equity issues plus net new debt issues. The p-value is calculated based on robust standard errors.

750 Z. Tong / Journal of Corporate Finance 17 (2011) 741758

unconstrained rms and constrained rms. Table 5B presents the results using the net change in cash holdings with the separation

of the sample by the level of corporate governance. Firm diversication has a negative (zero) impact on the value of cash among

the rms with a lower (higher) level of corporate governance. Table 5C presents the results for the sub-samples separated by both

nancial constraints and corporate governance. We get consistent results that agency problems prevail in the value of cash

holdings for diversied rms among both nancially unconstrained rms and constrained rms.

4.6. About the endogeneity

Campa and Kedia (2002) argue that rmdiversication can be an endogenous choice made by a rm, and they use econometric

techniques to control for the potential endogeneity problem. Other papers in the literature have expressed similar concerns (e.g.,

Graham et al., 2002). We follow Campa and Kedia (2002) and used three econometric methods to examine the impact of rm

diversication on the value of cash holdings while controlling for the endogeneity problem.

4.6.1. Methodology

The three econometric methods are the Heckman two-stage estimation, instrumental variables estimation and xed effect

estimation. Each of them addresses the endogeneity problem from a different perspective.

We apply the Heckman (1979) two-stage estimation to control for a rm's self-selection into diversication. In the rst stage,

we estimate a probit regression to model the decision of a rmto diversify. The variables are motivated by Campa and Kedia (2002)

and include various rm-specic, industry and macroeconomic characteristics that can inuence a rm's decision to diversify. We

use some two-year lagged variables (size, EBIT, and capital expenditures) in the probit regression, which reduces the sample size

Table 5B

The value of cash holdings: the impact of corporate governance alternative measure of the unexpected change in cash holdings.

Higher governance Lower governance

Gindexb7 (Bottom quartile) Gindex7

Coef. p-value Coef. p-value

Intercept 0.070 0.04 0.042 0.01

Net Cash Holdings 1.482 0.01 1.122 0.01

Firm DiversicationNet Cash Holdings 0.005 0.99 0.290 0.01

Firm Diversication 0.039 0.29 0.011 0.29

Earnings 0.800 0.01 0.530 0.01

Net Assets 0.350 0.01 0.269 0.01

R&D 0.628 0.62 0.476 0.21

Interest Expenses 1.460 0.25 2.370 0.01

Dividends 5.197 0.10 3.106 0.01

Cash Holdings

t 1

0.146 0.32 0.121 0.01

Leverage 0.107 0.34 0.101 0.01

Cash Holdings

t 1

Net Cash Holdings 1.590 0.02 0.842 0.01

LeverageNet Cash Holdings 0.604 0.25 0.860 0.01

New Financing 0.323 0.19 0.243 0.01

Observations 1608 6634

Adjusted R

2

0.10 0.12

The following table shows the marginal value of $1, calculated based on the estimates in the regressions. We conduct the F-test on the null hypothesis that the

marginal value of $1 is one, and we report the p-value in the brackets.

The marginal value of $1

Higher governance Lower governance

Gindexb7 (bottom quartile) Gindex7

Single-segment rms $1.20 (0.01) $0.86 (0.05)

Diversied rms $1.19 (0.02) $0.57 (0.01)

The following table shows the difference in the effect of diversication on the value of cash between high and lowgovernance rms and reports the p-value of the

t-test in the brackets.

Difference 0.285 (0.01)

This table reports the impact of corporate governance with an alternative measure of the unexpected change in cash holdings. The dependent variable is Excess

Return, dened as R

i,t

RB

i,t

. All variables except Excess Return, Firm Diversication, and Leverage are standardized by the lagged market value of equity. Gindex

is the corporate governance index constructed by Gompers et al. (2003). Cash Holdings is cash plus marketable securities. Net Cash Holdings is the realized

change in cash holdings minus the average change in cash holdings in the corresponding benchmark portfolio over the same period (see text for more details).

Firm Diversication is a dummy variable that equals 1 for diversied rms and 0 for single-segment rms. Earnings is the one-year change in earnings before

extraordinary items (Earnings

t

Earnings

t 1

). Net Assets is the one-year change in total assets minus cash holdings. R&D is the one-year change in research

and development expenses. Interest Expenses is the one-year change in interest expenses. Dividends is the one-year change in common dividends. Leverage is

the ratio of debt to total assets. New Financing is net new equity issues plus net new debt issues. The p-value is calculated based on robust standard errors.

751 Z. Tong / Journal of Corporate Finance 17 (2011) 741758

slightly to 27,767 rm-year observations due to incomplete data. Table 6A shows the probit regression. We obtain the Lambda from

the probit estimates. The calculation of Lambda follows the standard Heckman methodology and is reported in Appendix A. In the

second stage, we estimate the regressions with the Lambda as an additional control variable. This provides the treatment for a

rm's self-selection into diversication.

We use instrumental variables estimation to examine the underlying causal relations. We follow Campa and Kedia (2002) and

use the estimated probability of diversication from the probit model as a generated instrument. In the rst stage, we use all

exogenous variables and the probability of diversication as explanatory variables in the decision to diversify. In the second stage,

we use the tted value from the rst stage as an instrument for diversication to evaluate the effect of diversication on the value

of cash holdings. Campa and Kedia (2002) provide more details on the rationale of this methodology.

We introduce a two-way xed effect estimation to account for the omitted variable problem. Fixed rm effects and year effects

are used to control for unobservable rm characteristics and time effects. We exclude rms with only one observation during the

sample period in order to estimate the xed effect regression, thus leaving 27,151 rm-year observations in the sample.

4.6.2. Results

We report the results using the three econometric methods on the entire sample inTable 6B. The rst and second columns show

the second stage of the Heckman two-stage estimation. We nd that the marginal value of one dollar is $0.93 ($1.08) for diversied

Table 5C

Financial constraints and corporate governance alternative measure of the unexpected change in cash holdings.

Unconstrained Constrained

Higher governance Lower governance Higher governance Lower governance

Gindexb7

(bottom quartile)

Gindex7 Gindexb7

(bottom quartile)

Gindex7

Coef. p-value Coef. p-value Coef. p-value Coef. p-value

Intercept 0.046 0.15 0.049 0.01 0.054 0.25 0.064 0.01

Net Cash Holdings 1.333 0.01 1.244 0.01 1.720 0.06 1.245 0.01

Firm DiversicationNet Cash Holdings 0.031 0.96 0.398 0.05 0.034 0.92 0.341 0.03

Firm Diversication 0.067 0.07 0.041 0.02 0.015 0.75 0.021 0.34

Earnings 0.689 0.01 1.088 0.01 1.022 0.01 0.751 0.01

Net Assets 0.447 0.01 0.330 0.01 0.343 0.03 0.333 0.01

R&D 0.628 0.79 0.337 0.52 0.439 0.79 1.236 0.10

Interest Expenses 3.473 0.02 4.520 0.01 1.358 0.33 3.171 0.01

Dividends 2.244 0.49 2.983 0.05 9.572 0.15 7.025 0.01

Cash Holdings

t 1

0.140 0.35 0.032 0.70 0.225 0.27 0.207 0.01

Leverage 0.124 0.40 0.100 0.13 0.120 0.41 0.119 0.06

Cash Holdings

t 1

Net Cash Holdings 0.019 0.99 2.496 0.02 2.311 0.03 0.264 0.78

LeverageNet Cash Holdings 1.662 0.03 0.656 0.62 0.038 0.98 1.256 0.08

New Financing 0.375 0.13 0.280 0.01 0.340 0.25 0.235 0.03

Observations 518 2860 1090 3774

Adjusted R

2

0.18 0.14 0.10 0.15

The following table shows the marginal value of $1, calculated based on the estimates in the regressions. We conduct the F-test on the null hypothesis that the

marginal value of $1 is one, and we report the p-value in the brackets.

The marginal value of $1

Unconstrained Constrained

Higher governance Lower governance Higher governance Lower governance

Gindexb7 (bottom quartile) Gindex7 Gindexb7 (bottom quartile) Gindex7

Single-segment rms 1.00 (0.99) 0.83 (0.07) 1.45 (0.02) 0.97 (0.73)

Diversied rms 1.03 (0.65) 0.43 (0.01) 1.42 (0.02) 0.63 (0.03)

The following table shows the difference in the effect of diversication on the value of cash between high and lowgovernance rms and reports the p-value of the

t-test in the brackets.

Unconstrained Constrained

Difference 0.432 (0.01) 0.307 (0.02)

This table reports the results using the criteria of both nancial constraints and corporate governance. The regressions are presented across the groups of

nancially unconstrained/constrained rms and high/low governance rms. Payout is the criterion for nancial constraints. Gindex is the corporate governance

index constructed by Gompers et al. (2003). The dependent variable is Excess Return, dened as R

i,t

RB

i,t

. All variables except Excess Return, Firm

Diversication, and Leverage are standardized by the lagged market value of equity. Cash Holdings is cash plus marketable securities. Net Cash Holdings is the

realized change in cash holdings minus the average change in cash holdings in the corresponding benchmark portfolio over the same period (see text for more

details). Firm Diversication is a dummy variable that equals 1 for diversied rms and 0 for single-segment rms. Earnings is the one-year change in earnings

before extraordinary items. Net Assets is the one-year change in total assets minus cash holdings. R&D is the one-year change in research and development

expenses. Interest Expenses is the one-year change in interest expenses. Dividends is the one-year change in common dividends. Leverage is the ratio of debt

to total assets. New Financing is net new equity issues plus net new debt issues. The p-value is calculated based on robust standard errors.

752 Z. Tong / Journal of Corporate Finance 17 (2011) 741758

Table 6A

Probit regression.

Coef. p-value

Intercept 3.592 0.01

Size 0.071 0.01

Size t 1 0.020 0.45

Size t 2 0.085 0.01

EBIT 0.710 0.01

EBIT t 1 0.711 0.01

EBIT t 2 0.160 0.02

Capital Expenditures 0.562 0.01

Capital Expenditures t 1 0.220 0.07

Capital Expenditures t 2 0.017 0.87

S&P 0.115 0.01

Major stock exchange 0.010 0.69

Fraction of Diversied Firms in the Industry 1.889 0.01

Fraction of industry sales by diversied rms 0.555 0.01

GDP t 1 0.001 0.01

GDP growth 0.286 0.65

Observations 27,767

Pseudo R

2

0.14

This table reports probit estimates. The dependent variable takes the value 1 for diversied rms and 0 for single-segment rms. Size is the logarithmof sales. EBIT

is the ratio of earnings before interests and taxes to assets. Capital Expenditures is the ratio of capital expenditures to assets. S&P is a dummy that equals 1 when the

rm is part of the S&P index and 0 otherwise. Major Stock Exchange is a dummy that equals 1 if the rm is listed on Nasdaq, NYSE, or AMEX, and 0 otherwise.

Fraction of Diversied Firms in the Industry is the fraction of all the rms in the industry that are diversied rms. Fraction of Industry Sales by Diversied Firms

is the fraction of industry sales accounted for by diversied rms. GDP is Gross Domestic Product. GDP Growth is the growth rate of Gross Domestic Product. The

p-value is calculated based on robust standard errors.

Table 6B

Three econometric methods.

Heckman two-stage

estimation: second stage

Instrumental variables

estimation: second stage

Fixed effect estimation

(rm effects and year

effects not reported)

Coef. p-value Coef. p-value Coef. p-value

Intercept 0.012 0.18 0.052 0.01

Cash Holdings 1.316 0.01 1.435 0.01 1.278 0.01

Firm DiversicationCash Holdings 0.145 0.01 0.334 0.02 0.118 0.03

Firm Diversication 0.010 0.53 0.084 0.01 0.008 0.61

Earnings 0.672 0.01 0.640 0.01 0.566 0.01

Net Assets 0.293 0.01 0.234 0.01 0.210 0.01

R&D 0.689 0.01 0.385 0.01 0.486 0.01

Interest Expenses 1.416 0.01 1.307 0.01 0.894 0.01

Dividends 3.008 0.01 2.545 0.01 2.069 0.01

Cash Holdings

t 1

0.202 0.01 0.270 0.01 0.804 0.01

Leverage 0.168 0.01 0.160 0.01 0.422 0.01

Cash Holdings

t 1

Cash Holdings 0.797 0.01 1.545 0.01 0.842 0.01

LeverageCash Holdings 0.687 0.01 0.558 0.01 0.320 0.01

New Financing 0.020 0.48 0.062 0.02 0.085 0.01

Lambda 0.004 0.71

Observations 27,767 27,767 27,151

Adjusted R

2

0.13 0.12 0.14

The following table shows the marginal value of $1, calculated based on the estimates in the regressions. We conduct the F-test on the null hypothesis that the

marginal value of $1 is one, and we report the p-value in the brackets.

The marginal value of $1

Heckman two-stage estimation Instrumental variables estimation Fixed effect estimation

Single-segment rms $1.08 (0.01) $1.09 (0.01) $1.07 (0.03)

Diversied rms $0.93 (0.02) $0.76 (0.01) $0.95 (0.08)

This table reports the results using three econometric methods to control for the potential endogeneity problem (see text for more details). The dependent

variable is Excess Return, dened as R

i,t

RB

i,t

. All variables except Excess Return, Firm Diversication, and Leverage are standardized by the lagged market value

of equity. Cash Holdings is cash plus marketable securities. Cash Holdings is the one-year change in cash holdings (Cash Holdings

t

Cash Holdings

t 1

). Firm

Diversication is a dummy variable that equals 1 for diversied rms and 0 for single-segment rms. The tted value is used in the instrumental variables

estimation. Earnings is the one-year change in earnings before extraordinary items. Net Assets is the one-year change in total assets minus cash holdings.

R&D is the one-year change in research and development expenses. Interest Expenses is the one-year change in interest expenses. Dividends is the one-year

change in common dividends. Leverage is the ratio of debt to total assets. New Financing is net new equity issues plus net new debt issues. Lambda is obtained

from the probit estimates in Table 6A. The p-value is calculated based on robust standard errors.

753 Z. Tong / Journal of Corporate Finance 17 (2011) 741758

Table 6C

Heckman two-stage estimation nancial constraints and the impact of corporate governance.

Panel A. Financial constraints

Unconstrained Constrained

Coef. p-value Coef. p-value

Intercept 0.032 0.05 0.012 0.25

Cash Holdings 1.176 0.01 1.379 0.01

Firm DiversicationCash Holdings 0.225 0.06 0.133 0.03

Firm Diversication 0.019 0.47 0.020 0.32

Earnings 0.764 0.01 0.660 0.01

Net Assets 0.282 0.01 0.309 0.01

R&D 1.269 0.01 0.636 0.01

Interest Expenses 2.135 0.01 1.714 0.01

Dividends 2.854 0.01 3.804 0.01

Cash Holdings

t 1

0.146 0.01 0.245 0.01

Leverage 0.093 0.01 0.153 0.01

Cash Holdings

t 1

Cash Holdings 0.709 0.01 0.860 0.01

LeverageCash Holdings 0.112 0.79 0.718 0.01

New Financing 0.189 0.01 0.035 0.25

Lambda 0.019 0.27 0.012 0.36

Observations 6925 20,842

Adjusted R

2

0.12 0.14

The following table shows the marginal value of $1, calculated based on the estimates in the regressions. We conduct the F-test on the null hypothesis that the

marginal value of $1 is one, and we report the p-value in the brackets.

The marginal value of $1

Unconstrained Constrained

Single-segment rms $1.04 (0.40) $1.13 (0.01)

Diversied rms $0.82 (0.07) $0.99 (0.72)

Panel B. Corporate governance

Higher governance Lower governance

Gindexb7 (bottom quartile) Gindex7

Coef. p-value Coef. p-value

Intercept 0.075 0.23 0.043 0.11

Cash Holdings 1.535 0.01 1.156 0.01

Firm DiversicationCash Holdings 0.076 0.89 0.386 0.05

Firm Diversication 0.093 0.44 0.035 0.39

Earnings 0.792 0.01 0.715 0.01

Net Assets 0.353 0.01 0.377 0.01

R&D 0.627 0.62 0.714 0.18

Interest Expenses 1.388 0.27 3.286 0.01

Dividends 5.309 0.10 4.460 0.01

Cash Holdings

t 1

0.147 0.32 0.165 0.01

Leverage 0.094 0.41 0.128 0.01

Cash Holdings

t 1

Cash Holdings 1.807 0.01 0.675 0.39

LeverageCash Holdings 0.678 0.20 1.041 0.05

New Financing 0.341 0.17 0.334 0.01

Lambda 0.036 0.65 0.013 0.64

Observations 1608 6634

Adjusted R

2

0.10 0.14

The following table shows the marginal value of $1, calculated based on the estimates in the regressions. We conduct the F-test on the null hypothesis that the

marginal value of $1 is one, and we report the p-value in the brackets.

The marginal value of $1

Higher governance Lower governance

Gindexb7 (bottom quartile) Gindex7

Single-segment rms $1.20 (0.01) $0.87 (0.06)

Diversied rms $1.27 (0.01) $0.48 (0.01)

The following table shows the difference in the effect of diversication on the value of cash between high and lowgovernance rms and reports the p-value of the

t-test in the brackets.

Difference 0.462 (0.02)

754 Z. Tong / Journal of Corporate Finance 17 (2011) 741758

(single-segment) rms. The third and the fourth columns report the second stage of the instrumental variables estimation. The

marginal value of one dollar is $0.76 ($1.09) for diversied (single-segment) rms. We nd that the coefcient of the interaction

term, Firm DiversicationCash Holdings, is 0.334. The instrumental variables estimation reveals that diversication has a

more negative impact on the value of cash. The fth and the sixth columns show the results using xed effect estimation. We nd

that an additional dollar is worth $0.95 ($1.07) in diversied (single-segment) rms. These results are consistent with the

interpretation that rm diversication reduces the value of cash, controlling for the potential endogeneity problem.

Table 6D

Heckman two-stage estimation nancial constraints and corporate governance.

Unconstrained Constrained

Higher governance Lower governance Higher governance Lower governance

Gindexb7

(bottom quartile)

Gindex7 Gindexb7

(bottom quartile)

Gindex7

Coef. p-value Coef. p-value Coef. p-value Coef. p-value

Intercept 0.059 0.32 0.041 0.19 0.111 0.15 0.116 0.10

Cash Holdings 1.410 0.01 1.102 0.01 1.763 0.05 1.262 0.01

Firm DiversicationCash Holdings 0.017 0.98 0.362 0.04 0.015 0.90 0.328 0.04

Firm Diversication 0.155 0.15 0.062 0.18 0.202 0.16 0.152 0.15

Earnings 0.617 0.01 1.061 0.01 0.853 0.01 0.741 0.01

Net Assets 0.446 0.01 0.326 0.01 0.321 0.03 0.342 0.01

R&D 0.801 0.71 0.353 0.47 0.317 0.84 1.156 0.71

Interest Expenses 3.553 0.01 4.593 0.01 1.293 0.35 3.252 0.41

Dividends 2.452 0.44 3.158 0.03 7.817 0.17 7.134 0.18

Cash Holdings

t 1

0.152 0.27 0.032 0.72 0.253 0.20 0.217 0.16

Leverage 0.090 0.53 0.098 0.13 0.064 0.66 0.083 0.72

Cash Holdings

t 1

Cash Holdings 0.470 0.83 2.263 0.03 2.139 0.03 0.325 0.27

LeverageCash Holdings 1.702 0.01 0.102 0.94 0.298 0.86 1.245 0.01

New Financing 0.380 0.11 0.278 0.01 0.340 0.24 0.258 0.14

Lambda 0.059 0.37 0.020 0.54 0.119 0.20 0.098 0.15

Observations 518 2860 1090 3774

Adjusted R

2

0.19 0.14 0.09 0.15

The following table shows the marginal value of $1 calculated based on the estimates in the regressions. We conduct the F-test on the null hypothesis that the

marginal value of $1 is one, and report the p-value in the brackets.

The marginal value of $1

Unconstrained Constrained

Higher governance Lower governance Higher governance Lower governance

Gindexb7 (bottom quartile) Gindex7 Gindexb7 (bottom quartile) Gindex7

Single-segment rms 1.02 (0.95) 0.82 (0.06) 1.46 (0.03) 0.98 (0.83)

Diversied rms 1.04 (0.61) 0.46 (0.01) 1.45 (0.03) 0.65 (0.04)

The following table shows the difference in the effect of diversication on the value of cash between high and lowgovernance rms, and reports the p-value of the

t-test in the brackets.

Unconstrained Constrained

Difference 0.379 (0.03) 0.313 (0.04)

This table reports the results using the criteria of both nancial constraints and corporate governance. The regressions are presented across the groups of

nancially unconstrained/constrained rms and high/low governance rms. Payout is the criterion for nancial constraints. Gindex is the corporate governance

index constructed by Gompers et al. (2003). The dependent variable is Excess Return, dened as R

i,t

RB

i,t

. All variables except Excess Return, Firm

Diversication, and Leverage are standardized by the lagged market value of equity. Cash Holdings is cash plus marketable securities. Cash Holdings is the one-

year change in cash holdings (Cash Holdings

t

Cash Holdings

t 1

). Firm Diversication is a dummy variable that equals 1 for diversied rms and 0 for single-

segment rms. Earnings is the one-year change in earnings before extraordinary items. Net Assets is the one-year change in total assets minus cash holdings.

R&D is the one-year change in research and development expenses. Interest Expenses is the one-year change in interest expenses. Dividends is the one-year

change in common dividends. Leverage is the ratio of debt to total assets. New Financing is net new equity issues plus net new debt issues. Lambda is obtained

from the probit estimates in Table 6A. The p-value is calculated based on robust standard errors.

Notes to Table 6C:

This table reports the second stage of the Heckman two-stage estimation. The dependent variable is Excess Return, dened as R

i,t

RB

i,t

. Panel A presents the

results using payout as the criteria of nancial constraints. All variables except Excess Return, Firm Diversication, and Leverage are standardized by the lagged

market value of equity. Cash Holdings is cash plus marketable securities. Cash Holdings is the one-year change in cash holdings. Firm Diversication is a dummy

variable that equals 1 for diversied rms and 0 for single-segment rms. Earnings is the one-year change in earnings before extraordinary items. Net Assets is

the one-year change in total assets minus cash holdings. R&D is the one-year change in research and development expenses. Interest Expenses is the one-year

change in interest expenses. Dividends is the one-year change in common dividends. Leverage is the ratio of debt to total assets. New Financing is net new

equity issues plus net new debt issues. Lambda is obtained from the probit estimates in Table 6A. Panel B reports the impact of corporate governance. Gindex is

the corporate governance index constructed by Gompers et al. (2003). The p-value is calculated based on robust standard errors.

755 Z. Tong / Journal of Corporate Finance 17 (2011) 741758

We report the results using payout as the criteria of nancial constraints and the impact of corporate governance in Table 6C.

This table only shows the results of the Heckman two-stage estimation for brevity. We get consistent results using the other two

econometric methods. We nd that rm diversication reduces the value of cash holdings in both nancially unconstrained and

constrained rms, and that rm diversication has a negative (zero) impact on the value of cash among rms with a lower

(higher) level of corporate governance. We report the results for the sub-samples separated by both nancial constraints and

corporate governance in Table 6D. We nd consistent results. These results give further support to the agency hypothesis

controlling for the potential endogeneity problem.

4.7. Alternative measure of corporate governance

We conduct a robustness check using an alternative measure of corporate governance. Bebchuk et al. (2009) argue that 6 out of

24 provisions in the IRRC database are the most important ones leading to managerial entrenchment. They design an

Entrenchment index based on these six provisions. A higher Entrenchment index indicates more restrictions on shareholder rights,

thus corresponding to a lower level of corporate governance.

11

We use a similar methodology and divide the sample into two

groups. One group has a higher level of corporate governance (Eindexb2) and includes observations in the bottom quartile. The

other group has a lower level of corporate governance (Eindex2).

11

The Entrenchment index has a range of possible values from 0 to 6. See Bebchuk et al. (2009) for more details.

Table 7

The impact of corporate governance alternative measure of governance.

Higher governance Lower governance

Eindexb2 (bottom quartile) Eindex2

Coef. p-value Coef. p-value

Intercept 0.032 0.27 0.046 0.01

Cash Holdings 1.312 0.01 1.206 0.01

Firm DiversicationCash Holdings 0.041 0.97 0.322 0.01

Firm Diversication 0.032 0.27 0.021 0.04

Earnings 0.816 0.01 0.738 0.01

Net Assets 0.344 0.01 0.377 0.01

R&D 0.878 0.43 0.376 0.22

Interest Expenses 2.329 0.03 3.159 0.01

Dividends 4.497 0.16 4.783 0.01

Cash Holdings

t 1

0.100 0.34 0.174 0.01

Leverage 0.087 0.30 0.141 0.01

Cash Holdings

t 1

Cash Holdings 1.101 0.03 0.332 0.34

LeverageCash Holdings 0.064 0.89 1.609 0.01

New Financing 0.237 0.12 0.375 0.01

Observations 2374 5868

Adjusted R

2

0.10 0.14

The following table shows the marginal value of $1 calculated based on the estimates in the regressions. We conduct the F-test on the null hypothesis that the

marginal value of $1 is one, and report the p-value in the brackets.

The marginal value of $1

Higher governance Lower governance

Eindexb2 (bottom quartile) Eindex2

Single-segment rms $1.18 (0.03) $0.85 (0.04)

Diversied rms $1.22 (0.03) $0.53 (0.01)

The following table shows the difference in the effect of diversication on the value of cash between high and lowgovernance rms and reports the p-value of the

t-test in the brackets.

Difference 0.363 (0.01)

This table reports the impact of corporate governance using an alternative measure of governance. The dependent variable is Excess Return dened as R

i,t

RB

i,t

.

All variables except Excess Return, Firm Diversication, and Leverage are standardized by the lagged market value of equity. Eindex is the entrenchment index

constructed by Bebchuk et al. (2009). Cash Holdings is cash plus marketable securities. Cash Holdings is the one-year change in cash holdings (Cash Holdings

t

Cash Holdings

t 1

). Earnings is the one-year change in earnings before extraordinary items. Net Assets is the one-year change in total assets minus cash

holdings. R&D is the one-year change in research and development expenses. Interest Expenses is the one-year change in interest expenses. Dividends is the

one-year change in common dividends. Leverage is the ratio of debt to total assets. New Financing is net new equity issues plus net new debt issues. The p-value

is calculated based on robust standard errors.

756 Z. Tong / Journal of Corporate Finance 17 (2011) 741758

We report the results in Table 7. We nd that the coefcient of the interaction term, Firm DiversicationCash Holdings, is

0.041 (p-value=0.97) in the group with a higher level of corporate governance. We also nd that the coefcient of the

interaction term, Firm DiversicationCash Holdings, is 0.322 (p-value=0.01) in the group with a lower level of corporate

governance. The results imply that rm diversication has a negative (zero) impact on the value of cash among rms with a

lower (higher) level of corporate governance. We therefore nd consistent results using this alternative measure of corporate

governance.

4.8. Alternative sample period

We conduct the robustness check using the data from 1990 to 1996, to ensure that the effect is not conned to recent

years. We report the regressions for the entire sample in Table 8. We nd that an additional dollar is worth $1.07 in single-

segment rms, while it is worth $0.92 in diversied rms. Both are signicantly different from one. We nd consistent

results by separating the sample by the criteria of nancial constraints, as well as by using the measures of corporate

governance.

5. Conclusion

We study the relation between rm diversication and the value of corporate cash holdings. We develop two hypotheses

based on different theories of rm diversication. We use the methodology in Faulkender and Wang (2006) and nd that

the marginal value of one dollar in diversied (single-segment) rms is $0.92 ($1.08). The ndings imply that the same

dollar is valued 16 cents less in diversied rms than in single-segment rms. We nd that rm diversication reduces the

value of cash in both nancially unconstrained and constrained rms. We nd that rm diversication has a negative (zero)

impact on the value of cash among rms with a lower (higher) level of corporate governance. We obtain similar results

when we use an alternative measure of the unexpected change in cash holdings, three econometric methods to control for

the potential endogeneity problem, an alternative measure of corporate governance, and the data in a different sample

period.

These ndings are consistent with the predictions of the agency hypothesis. We conclude that rm diversication reduces the

value of corporate cash holdings through agency problems.

Table 8

The value of cash holding robustness check: sample period 19901996.

Coef. p-value Coef. p-value

Intercept 0.002 0.78 0.001 0.99

Cash Holdings 1.130 0.01 1.177 0.01

Firm DiversicationCash Holdings 0.145 0.04

Firm Diversication 0.003 0.68

Earnings 0.621 0.01 0.617 0.01

Net Assets 0.337 0.01 0.339 0.01

R&D 1.016 0.01 1.019 0.01

Interest Expenses 1.220 0.01 1.199 0.01

Dividends 2.246 0.01 2.228 0.01

Cash Holdings

t 1

0.184 0.01 0.157 0.01

Leverage 0.253 0.01 0.255 0.01

Cash Holdings

t 1

Cash Holdings 0.373 0.01 0.262 0.01

LeverageCash Holdings 0.305 0.01 0.307 0.01

New Financing 0.058 0.02 0.049 0.02

Observations 26,861 26,861

Adjusted R

2

0.14 0.14

The following table shows the marginal value of $1 calculated based on the estimates in the regressions We conduct the F-test on the null hypothesis that the

marginal value of $1 is one, and report the p-value in the brackets.

The marginal value of $1

Entire sample $1.01(0.81) Single-segment rms $1.07 (0.07)

Diversied rms $0.92 (0.05)

This table reports the value of cash holdings using the data in 19901996. The dependent variable is Excess Return dened as R

i,t

RB

i,t

. All variables except

Excess Return, Firm Diversication, and Leverage are standardized by the lagged market value of equity. Cash Holdings is cash plus marketable securities. Cash

Holdings is the one-year change in cash holdings (Cash Holdings

t

Cash Holdings

t 1

). Firm Diversication is a dummy variable that equals 1 for diversied rms

and 0 for single-segment rms. Earnings is the one-year change in earnings before extraordinary items. Net Assets is the one-year change in total assets minus

cash holdings. R&D is the one-year change in research and development expenses. Interest Expenses is the one-year change in interest expenses. Dividends

is the one-year change in common dividends. Leverage is the ratio of debt to total assets. New Financing is net new equity issues plus net new debt issues. The

p-value is calculated based on robust standard errors.

757 Z. Tong / Journal of Corporate Finance 17 (2011) 741758

Appendix A. Denition of variables

R

i,t

R

i,t

is rm i's stock return over scal year t 1 to t.

RB

i,t

RB

i,t

is stock i's benchmark return over scal year t 1 to t. The benchmark portfolio is one of the 25 Fama

and French portfolios formed based on rm size and book-to-market.

Excess Return Excess Return is dened as R

i,t

RB

i,t

.

MV

i,t 1

MV

i,t 1

is market value of equity at time t 1 computed as price (Compustat item #199) times shares outstanding (#25).

Cash Holdings Cash Holdings is dened as cash and marketable securities (#1).

Earnings Earnings is dened as earnings before extraordinary items (#18+#15+#50+#51).

Net Assets Net Assets is dened as total assets minus cash holdings (#6#1).

R&D R&D is dened as research and development expenses (#46).

Interest Expenses Interest Expenses is dened as interest expenses (#15).

Dividends Dividends is dened as common dividends (#21).

New Financing New Financing is dened as net new equity issues (#108#115) plus net new debt issues (#111#114).

Leverage Leverage is dened as the sum of long-term debt (#9) and debt in current liability (#34), divided by total assets (#6).

Firm Diversication Firm Diversication is a dummy variable that equals 1 for diversied rms and 0 for single-segment rms.

Lambda We assume that a rm's decision to diversify is determined by the equations

D

it

=Z

it

+u

it

D

it

=1, if D

it

N0

D

it

=0, if D

it

b0,

where D

it

it

is a dummy variable (1 for diversied rms and 0 for

single-segment rms). Z

it

is a set of variables that affect a rm's decision to diversify, and u

it

is an error term.

We rst estimate the above equation using a probit model to obtain the estimates of denoted by

e

.

Lambda is calculated as follows:

Lambda

it

=

/

e

Z

it

e

Z

it

D

it

+

/

e

Z

it

1

e

Z

it

1 D

it

;

where the density function of the standard normal distribution. is the cumulative distribution function of the

standard normal distribution, and D

it

is a dummy variable (1 for diversied rms and 0 for single-segment rms).

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