**2. Review of Literature**

A corporate diversification strategy deals with business expansion and profit maximization of a firm. The modern portfolio theory of Markowitz (1952) states that diversification in various investment projects leads to minimize risk and maximize expected return. In agency theory, the literature shows that managers work for their personal benefits at the expense of shareholders by using diversification strategies (Jensen and Meckling 1976; Denis et al. 1997). Lins and Servaes (2002) explain that the utilization of internal capital is an attraction for diversification due to imperfection in the external capital market. The concept explains a positive relationship between corporate diversification and firms' value because a firm has informational advantages in raising capital and it can avoid the costs of external financing, which is greater than the cost of internal financing.

To meet challenges and survive in the markets, firms make diversification decisions. Management of the firms decide whether to go for related or unrelated diversification. If firms opt for related diversification, that provides good output and reduces total risk. However, if managemen<sup>t</sup> goes for unrelated diversification, it may have a negative impact on firm value. Corporate diversification strategy helps firms to expand business activities and ge<sup>t</sup> maximum profit (Phung and Mishra 2016). According to Pandya and Rao (1998), diversified firms perform better on risk and return basis. According to Phung and Mishra (2016), there is a negative impact of diversification on financial performance. This negative impact is due to a weak and inefficient corporate governance system, which motivates firms to diversify and ultimately negatively affects the firms' financial performance. Furthermore, inefficient diversification strategy negatively affects the firms' financial performance (Berger and Ofek 1995). The literature states that diversification is important and has the potential to increase the firms' financial performance. Therefore, the impact of diversification on the firms' financial performance depends on its effective management.

### **Hypothesis 1 (H1).** *Corporate diversification positively affects the firm's financial performance.*

When firms make diversification decisions, financial structure is an important factor which affects the firms' financial performance. Zulkafli et al. (2015) consider financing, investment, and dividend policies as corporate financial structure. Proper managemen<sup>t</sup> of financial decisions (investment, financing, working capital, and dividend policy) is essential for the firms' financial performance (Butt et al. 2010). However, we investigate the impact of capital structure on the firms' financial performance. Based on some assumptions, Modigliani and Miller (1958) state that capital structure does not affect the firm's value. Later, Modigliani and Miller (1963) sugges<sup>t</sup> that with an increase in taxes and deductible interest expenses, a firm prefers debt financing instead of equity financing. It shows that they have a different opinion when they consider the effects of tax shield and capital market imperfection. They revise their arguments and explain that capital structure affects the value of the firm due to the cost of debt. Myers and Majluf (1984); Myers (1984) explain Pecking Order Theory when a firm opts for internal rather than external sources of financing. Equity and debt financing bear the capital cost; therefore, it is not a cheap source of financing. A firm opts debt financing as it bears less cost as compared to equity financing. Dividend payments also give information to shareholders about firms' financial performance. This is among the major financial decisions that top managemen<sup>t</sup> takes (Baker

et al. 2001). The business activities and growth depend on the financial structure of a firm. Firms need to make an investment decision with grea<sup>t</sup> care as this demands the estimation of the value of certain projects based on timing, size, and estimation of the cash flow of the future.

Butt et al. (2010) sugges<sup>t</sup> that capital structure and dividend payments are important elements of firm growth and they find the positive impact of capital structure on the firms' financial performance. Safieddine and Titman (1999) state a positive impact of debt financing on the firms' financial performance. According to Gleason et al. (2000), capital structure and firms' financial performance have a negative relationship. Yat Hung et al. (2002); Salim and Yadav (2012) find a negative impact of capital structure on the firms' financial performance because the increase in leverage enhances the chances of bankruptcy cost which in turn decreases financial performance. Firms face financing obstacles, which slow down the firms' growth (Beck and Demirguc-Kunt 2006). The negative impact of capital structure on the firms' financial performance confirms the Pecking Order Theory of Myers and Majluf (1984) which explains that when firms go for more debt financing, they earn less profit. Literature leads us to think that the relationship between capital structure and firms' financial performance and shareholders' wealth is still present. The firms should generate optimal capital structure in order to maximize wealth for shareholders.

### **Hypothesis 2 (H2).** *Capital structure negatively affects the firm's financial performance.*

Does the dividend paymen<sup>t</sup> policy affect the value of a firm? There are different views in the literature about dividend policy and the value of a firm. Literature states that when firms buy back their stock, it gives a signal about undervaluation of stock prices of firms. This ultimately positively influences the firms' return because it creates wealth for stockholders along with an increase in share prices. The bird in hand theory of Gordon (1963) and the dividend growth model of Walter (1963) explain the relevance of dividend paymen<sup>t</sup> and further explain that dividend paymen<sup>t</sup> affects the value of the firms. Butt et al. (2010); Ali et al. (2015) find that dividend policy positively affects the firm's financial performance. Hunjra (2018) proves a significant role of dividend payments towards the firm's financial performance and support the relevancy school of thought. The concepts describe that dividend is less risky as compared to capital gain. Therefore, investors prefer dividend instead of receiving capital gain. This means that dividend payments increase the value of the firm. Titman et al. (2004); Cooper et al. (2008) state that dividend paymen<sup>t</sup> has a negative impact on firms' financial performance.

### **Hypothesis 3 (H3).** *Dividend policy positively affects the firm's financial performance.*

Investment decision-making is another important component of the financial structure of the firm. The purpose of every investment is to earn the profit. Thus, investment decision-making directly affects the firms' financial performance. Miller and Modigliani (1961) present irrelevance proposition of dividend and explain that dividend paymen<sup>t</sup> does not affect the value of the firms rather investment decision affects the firm's value. Chen and Ho (1997); Chung et al. (1998); Jiang et al. (2006) show a positive impact of investment plans on the firm's financial performance. Titman et al. (2004) and Cooper et al. (2008) state investment decision has a negative impact on financial performance. The firms having an investment in fixed assets are less likely to have liquid assets. Therefore, firms having more liquid assets are likely to capitalize on long-term investment opportunities.

### **Hypothesis 4 (H4).** *Investment policy positively affects the firm's financial performance.*

We have incorporated a set of control variables in our study (i.e., corporate governance, firm age, and firm size and growth). Firms can generate more capital for investment and improve their financial performance by applying good corporate governance practices. In a competitive environment, effective corporate governance is important for economic development (Boubaker and Nguyen 2015). Jensen and Meckling (1976) present agency theory which explains that in a corporate governance system, managers work for their self-interest instead of owners' interest which results in inefficient allocation of resources and a decrease in financial performance. Due to availing personal benefits, managemen<sup>t</sup> makes a decision like diversification. The theory supports the fact that agency conflicts negatively affects the firms' financial performance. Corporate governance minimizes the agency problem as individual and institutional investors prefer firms which are well governed. On the contrary, Stewardship theory explains that managers focus only on the collective wellbeing of the firms regardless of the self-interest of the managers (Donaldson and Davis 1991). Therefore, this theory suggests that firms can increase their financial performance if the top-level managemen<sup>t</sup> possesses more power and they develop trust in running business affairs.

The literature explains the impact of corporate governance on firm's financial performance. Board of directors is a fundamental element of a firm's corporate governance structure (Black et al. 2009). Yermack (1996) finds a negative impact of board size on the financial performance of large firms in USA. Mak and Kusnadi (2005) find a negative impact of board size on firms' financial performance. Kiel and Nicholson (2003); Dar et al. (2011) find a positive impact of board size on the firm's financial performance. The literature states that board size is an important element of a good corporate governance practice. Bhagat and Bolton (2008); Ehikioya (2009) reveal a negative and significant relationship between CEO duality and firm's financial performance. The positive relationships between corporate governance mechanisms and financial performance show efficient managemen<sup>t</sup> of corporate governance system. The negative relationship validates Agency Theory and indicates the situations where managemen<sup>t</sup> performs for their own best interest with the investment of owners.

The auditor's full independent opinion after audit leads to audit quality (DeAngelo 1981). An audit committee performs an important and monitoring part to ensure the quality of the firm's accountability and financial statements (Carcello and Neal 2003). Resource dependence theory suggests that the large size of the audit committee can bring good resources into the firm like experience and skills. This shows the effectiveness of audit work while monitoring the operations of managemen<sup>t</sup> that improves the firms' financial performance (Pearce and Zahra 1992). External audit quality in terms of big audit firms is also an important element of the audit committee. DeAngelo (1981) argues that the big four firms provide better audit quality which enhances the firms' financial performance. Bauer et al. (2009) find a positive impact of large audit committee size on the firms' financial performance. The frequency of audit committee meetings ensures the activeness of the audit committee, which improves the financial performance of the firms. Vafeas (1999); Xie et al. (2003) find the frequency of audit committee meetings has a positive impact on firms' financial performance. Considering the above studies, we take an audit committee and audit quality in our study to check their impact on the firms' financial performance as they enhance the quality of financial reporting and financial performance.

Large board size enhances the utilization of the firm's useful resources (Boubaker and Nguyen 2012). Hence, large firms have more opportunities to gain economies of scale and economies of scope. Firm size has a positive impact on the firm's financial performance (Titman and Wessels 1988; Frank and Goyal 2003; Hunjra et al. 2014). It is argued that firms with large size faceless financial distress and generate more profit (Titman and Wessels 1988). The firms' financial performance also depends on growth opportunities and the firms' age. Firm age is important in a way that it explains about the experience of the firm in its operations. Muritala (2012); Hunjra et al. (2014); Lazar (2016) find that firm growth and firm age have a positive impact on firms' financial performance. The positive impact of growth indicates the opportunities for the firms to expand business and earn more profit. Pervan et al. (2017) present a theoretical discussion about the positive and negative impact of age on financial performance. Firms with old age have more abilities, experience, good technology, skilled labor, and learning environment, which help them to increase financial performance. On the contrary, older firms face the situation where there is a reduction in flexibility and ability to make immediate changes and take quick decisions. With the increase in age, firms also avoid taking the risk.
