We propose a theory of corporate liquidity management in which signaling through illiquidity is cheaper than signaling through “skin in the game.” This causes ex post liquidation of worthy projects even when there are enough aggregate resources available for their continuation. We examine the policy remedies for this distortion and consider their consequences for the supply of liquidity, interest rate policy, and subsidies.

We consider consumer responsiveness to changes in the macroeconomic environment (i.e. product demand sensitivity) to be a systematic industry characteristic useful to studying how industrial diversification adds value. We argue that diversified firms, with the advantages of their internal capital market and the imperfectly correlated cash flows of their segments, will perform better than focused firms when the demand sensitivity of a product increases. Our empirical evidence reveals a significant diversification premium associated with an increase in sensitivity. Moreover, such premium predominantly exists during recessionary periods, disappearing in the presence of low coinsurance and inefficient use of the internal capital market. Our results are robust to alternative measures of sensitivity and performance metrics, different empirical model specifications, and to the concern of possibly biased estimations associated with the sample of diversified and focused firms.