The relationship between capital structure and diversification strategy

The aim of this paper is to analyze the relationship between capital structure and diversification strategy. In literature, analyses and reviews of different approaches confirm that diversification can have three basic effects on capital structure: 1) The coinsurance effect (Bergh, 1997), predicting a positive relationship between debt level and the degree of diversification; 2) The transaction cost theory (Williamson, 1988), also predicting a positive relationship; and 3) The agency cost explanation (Jensen and Meckling, 1976), predicting a negative relationship. The majority of empirical studies do not consider diversification as a determinant of capital structure but admits a compatibility with the strategic profile of the firm in order to take part in the value creation process. Equity financing is preferred for related diversification, since unrelated is associated with debt financing. Finally it is profitability that partially explains the relationship between debt level and diversification strategy.