Asset Tangibility, Macroeconomic Risks, and the Diversification Discount

This paper develops a structural model of firm diversification to study the role of organizational flexibility as a tool to manage liquidity in the presence of aggregate productivity and financial shocks. The model features endogenous diversification and refocusing in a two sector economy, where each sector is characterized by a different level of asset tangibility. The estimated model is able to generate the average diversification discount as well as its substantial decrease during recessions and credit crunches as observed in the data. This decrease in the discount can be attributed to tighter collateral constraints of young single-segment firms with low asset tangibility. Counterfactual experiments show that the value of organizational flexibility -the ability to dynamically diversify and refocus- accounts for 10.5% of firm value, of which we attribute 38% to financial pooling benefits and 62% to the option to refocus.