The effect of diversification on capital structure

Previously, empirical financial studies paid little attention to the role of diversification strategy on financial choices. The aim of the present study is to analyze the financing strategies of multibusiness firms, suggesting the relevance of sorting the diversification phenomena into its related and unrelated components. The implications of our findings are very relevant in that they explain earlier contradictory results on capital-structure determinants. The degree of product specialization/diversification and the direction of diversification (related or unrelated) translate into different corporate financial behaviours. In particular, the two types of diversification- related or unrelated, had opposite effects on debt. Specifically, a related-diversification strategy, which is associated with lower debt ratios, has a negative influence on leverage. By contrast, unrelated diversity, which is associated with higher debt usage, has a positive effect on debt. According to the coinsurance effect and the transaction-cost hypothesis, unrelated-diversified firms have a higher debt capacity and can assume more debt as a source of finance. Moreover, the capital-structure decisions of unrelated-diversified firms seem to be strictly aimed at reaching their target optimal debt level—a behaviour that is consistent with the trade-off hypothesis. On the other hand, related-diversified firms adjust more slowly towards their target capital structure