The More-Money and Less-Cash Effects of Diversification: Evidence from Japanese firms

Firms that operate in multiple industries can use cash flow generated by a business to fulfill the debt obligations and investment needs of other businesses. Because of such coinsurance effect, industrial diversification may increase firms' optimal leverage and also enable them to hold less liquidity for precautionary motives. I examine this possibility based on a sample of public Japanese firms. Regressions show that after controlling for various determinants of capital structure, diversified firms are significantly more leveraged, while holding less cash, than representative focused firms in the same industries. Moreover, these effects are stronger for more diversified firms and robust to control for unobserved heterogeneity and endogeneity. My results lend support to the view that diversification increases the financial flexibility of firms by enlarging the size and scope of internal capital markets.