How firm boundaries and relatedness jointly affect diversification value: trade-offs between governance and flexibility

Abstract

Diversification involves ongoing decisions about firm boundaries and relatedness. We develop a theoretical model that uses a real-option framework combined with optimal mechanism design to analyze how choices of boundaries and relatedness affect firm performance in the face of tradeoffs between governance and flexibility. We find that: (1) optimal boundaries and relatedness are substitutes in determining firm performance; (2) the association between relatedness, the most commonly studied aspect of diversification, and firm performance is indeterminate; (3) the substitution between relatedness and boundaries declines as noise in internal communication increases; (4) variation in relatedness has greater impact than boundary size when headquarters can pick multiple winners; and (5) as the internal market for information becomes more efficient, the lower the value of relatedness in combination with small boundaries. The general conceptual implication of these points is that corporate governance interacts with firm relatedness and boundaries in generating diversification performance.