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We find that diversified firms in New Zealand are associated with a value discount of 19-42 per cent relative to single-segment (undiversified) firms. Although several competing explanations have been offered in the literature, we find that the strength of corporate governance explains between 15-21 per cent of this discount. Specifically, board size, busyness of directors, CEO ownership and whether or not compensation of directors includes equity-based components collectively explain a large part of the reported discount. Our results from companies trading in New Zealand complement recent findings in the US by not only confirming the existence of a diversification discount but also emphasizing the role of poor governance in destroying shareholder wealth by pursuing a value-destroying corporate strategy. All our results hold after controlling for potential endogeneity in the decision to diversify and the choice of corporate governance structure by employing two-way fixed-effects and dynamic-panel generalized method of moments regression techniques.

We find very strong and consistent evidence that investments in StrongGovernance firms (managers not entrenched) are strongly sensitive to availability of internal cash flows while such sensitivity is not different from zero for Weak-Governance firms (entrenched management). We interpret this as evidence in support of Kaplan and Zingales' (1997) contention that sensitivity of investments to cash flows is not an adequate measure of financing constraints. More importantly, our findings are consistent with Kaplan and Zingales' conjecture that the observed sensitivity of investments to cash flows in firms that do not face financing constraints may be driven by excessive risk aversion of managers.

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