Asset Sales Improve Investment Policies for Remaining Divisions
Following the sale of a business segment, diversified firms show improved management of their retained operations, leading to a reduction of their "diversification discount."
ANN ARBOR, Mich. Diversification may produce larger companies, but not necessarily more efficient ones because managers often undertake value-decreasing investments and subsidize poorly performing segments by draining resources from more valuable segments, according to a new University of Michigan Business School study.
In addition, there is frequently misalignment in the incentives between central and division managers, the study shows. This investment inefficiency is part of the reason why diversified firms generally trade at a discount relative to stand-alone firms.
The study, recently published in the Journal of Finance, suggests that when diversified firms divest an entire business segment, they experience a substantial improvement in the efficiency of investment in their remaining divisions and a reduction in the "diversification discount." The asset sale increases corporate focus, enabling business organizations to make better decisions about capital allocation.
In "Divestitures and Divisional Investment Policies," researchers Amy Dittmar, assistant professor of finance at the Michigan Business School, and Anil Shivdasani, professor of finance at the University of North Carolina, examined 278 divestitures made by 235 firms between 1983 and 1994. The typical divestiture yielded proceeds large enough to have a substantial impact on the firm's investment policy.
The results show a significant decrease in the diversification discount following an asset sale for the 235 firms in the study.
However, all firms, including those with only one ongoing segment after the divestiture, continue to trade at a discount relative to other stand-alone firms.
In addition, there are significantly positive "announcement returns" associated with public disclosure of divestiture, the researchers say. These returns also are linked with the change in the diversification discount. Thus, the decrease in the diversification discount is consistent with an increase in firm value.
After the sale of a business segment, diversified parent companies make a significant shift in the investment policy for their remaining divisions, according to Dittmar and Shivdasani. Investment declines for segments where previously there was over-investment relative to single-segment firms and increases for under-invested segments that offer better investment possibilities, although the investment level remains suboptimal compared to stand-alone companies.
Furthermore, sales of assets provide an expedient financing mechanism when access to external capital is limited, they say. The relaxed financial constraints enable firms to invest in value-adding projects that otherwise would not have been funded.
The researchers cite the case of Disney, which divested its cmmunity development segment in 1987 for $400 million and concurrently increased investment in its consumer-products division more than 2,100 percent. The company also poured more money into its filmed entertainment and theme parks and resorts segments. These events illustrate how proceeds from divestiture can provide financing for segment investment.
Dittmar and Shivdasani conclude that asset sales lead to more efficient investment policies, enabling firms to improve the management of their retained operations.
"Changing the organizational structure through the divestiture of a business segment has a positive impact on corporate focus and capital allocation and, ultimately, reduces the diversification discount," Dittmar says. "This indicates that inefficient divisional investment policies are at least partly responsible for the discounted value of diversified companies."
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