Strategic Cost of Diversification Evgeny Lyandres Rice University This article proposes a new explanation for the large cross-sectional variation in the excess values of diversified firms. The model applies the idea of shareholders’ limited liability affecting firms’ output market strategies to the analysis of financial and operating choices of conglomerates. The inability of conglomerates to commit to unconstrained optimal operating strategies, following from the lack of flexibility in choosing their divisions’ capital structures, reduces their value. Thus, the model highlights a new type of inefficiency of the conglomerate organizational structure, which is suboptimal financing. The predictions of the model are generally supported by the data. (JEL G32, G34, L13) The valuation of diversified firms (conglomerates) that operate divisions in multiple industries has attracted significant attention in recent years. Early evidence suggests that conglomerates are discounted, on average, relative to their single-division rivals (e.g., Lang and Stulz (1994), Berger and Ofek (1995), Lins and Servaes (1999), and Klein (2001)). More recent studies show that carefully controlling for the endogeneity of the decision to diversify reduces conglomerate discounts and, in some cases, results in diversification premiums (e.g., Campa and Kedia (2002) and Villalonga (2003, 2004)). Regardless of whether conglomerates trade at a discount or premium on average, there is no debate about the existence of a large cross-sectional variation in conglomerate discounts/premiums. All of the studies above have found that some diversified firms trade at substantial discounts, while others trade at sizeable premiums. The variation in conglomerates’ excess values is due to various costs and benefits of diversification. The benefits are numerous. Economies of scope can allow greater operating efficiency. The convexity of the tax code creates tax advantages that follow from a smoother profit stream. Diversification can mitigate Myers (1977) underinvestment problem by creating larger internal capital markets (see Stulz (1990)), reduce the I would like to thank an anonymous referee, Robert McDonald (the editor), Rui Albuquerque, Mike Barclay, Gennaro Bernile, Mark Bils, Jim Brickley, Gustavo Grullon, Ronald Jones, Erwan Morellec, Bill Schwert, Cliff Smith, James Weston, Alexei Zhdanov, and seminar participants at Ben Gurion University, Hebrew University, HEC Montreal, Norwegian School of Management BI, Tel Aviv University, University of California at Riverside, University of Rochester, and University of Utah for very helpful comments and suggestions. All remaining errors are mine only. Address correspondence to Evgeny Lyandres, Jones Graduate School of Management, Rice University, Houston, TX 77005, or e-mail: lyandres@rice.edu.  The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org. doi:10.1093/rfs/hhm047 Advance Access publication September 28, 2007