A Theory of Corporate Scope and Financial Structure


  • DAVID D. LI,


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    • D. D. Li is from the University of Michigan. S. Li is from Goldman Sachs & Co. We are grateful for the guidance of Oliver Hart and David Scharfstein. We also thank Andrew Alford, Patrick Bolton, Chyi-Mei Chen, Judy Chevalier, Ludwig Chinearini, Drew Fudenberg, Peter Klibanoff, John Moore, Walter Novaes, Klaus Schmidt, Jeremy Stein, Chris Snyder, Lakshmi Shyam-Sunder, Jean Tirole, and Jean-Luc Vila for helpful comments and discussions. We are also grateful for comments and suggestions by the editor, René Stulz, and an anonymous referee.


We simultaneously address three basic issues regarding the corporation: the optimal scope of operation, the optimal financial structure, and the relationship between these two. The starting point is that financial structure serves as a bonding device on the managers' self-interest behavior. The effectiveness of this bonding depends on the distribution of the firm's future cash flow, which in turn depends on the firm's scope. Our theory also links the firm's investment decisions to its operation scope. As empirical implications, the theory reconciles the failure of the 1960s U.S. conglomerates with the success of the Japanese Keiretsu.