Global Diversification and the Cost of Equity

Abstract

The conventional view in the standard finance textbooks is that organizational form does not matter for a firm’s cost of capital because firm diversification reduces only idiosyncratic risk and not systematic risk. In this study, we investigate the effect of global diversification on the ex-ante cost of equity implied by the residual income valuation model (Ohlson, Earnings, book value and dividends in security valuations. Contemporary Accounting Research, 11(2), 661–687, 1995), using a sample of US firms from 1997 to 2019. Employing the empirical approach developed in Easton et al. (Using forecasts of earnings to simultaneously estimate growth and the rate of return on equity investment. Journal of Accounting Research, 40(3), 657–676, 2002), our results suggest that global diversification reduces the cost of equity capital for both single-segment firms and multi-segment firms. Our results highlight the effect of global diversification on the equity risk reduction, which may explain the increasing proliferation of foreign operations among US firms — a trend that neither the cash flow effect nor the capital structure effect proposed in previous studies can explain.