Corporate Diversification, Cost of Capital, Financial Policies and Firms Performance: Evidence from Pakistan

Abstract

Diversification has become a popular practice for firm expansion and growth. When firms go for diversification strategy, they need extra capital and they have to manage cost of capital and other financial policies. This research examines the effect of corporate diversification, cost of capital and financial policies on firms’ financial performance. The population of the study is manufacturing firms of Pakistan, with the sample being from 2004 to 2017. Two-step dynamic estimation was used for the analysis. Data was collected from DataStream. Financial performance of firms is measured through Return on Assets (ROA), Return on Equity (ROE) and Tobin’s Q. First, overall analysis of manufacturing sector was done followed by sectoral analysis. In the first and second models, Product Diversification (PD) and Geographic Diversification (GD) were used to measure corporate diversification. In the third model, the combined effect of PD and GD was analyzed. Firms’ financial policies measured as capital structure decision, dividend policy, investment policy, corporate governance, and audit quality are included in firms’ financial policies. Overall analysis reveals that both measures of corporate diversification have a significant impact on ROE and Tobin’s Q. Cost of capital, capital structure and dividend policy have a significant effect on all three measures of financial performance. Investment policy has an insignificant effect on financial performance. Analysis reveals mixed findings regarding the impact of corporate governance and audit quality on ROA and ROE. However, these variables have significant impact on Tobin’s Q. Sectoral analysis reveals mixed results depending on the nature, features and policies of the sectors. It is recommended that firms may manage diversification strategy and financial policies to make rational decision to improve the firms’ financial performance.