Does corporate diversification really cause a discount effect? A stream of burgeoning literature suggests the association between corporate diversification and substantial reduction in firm value. Most of former researches attribute the causes of discount effect of corporate diversification to the inefficient cross-subsidization, which can be referred to the agency problems. However, with higher level of liquidity, would firms adopting diversification strategy still suffer from a low valuation of firm value? Or they would benefit from the value-added effect of corporate liquidity?
Recent stream of literatures has a considerable discussion on corporate liquidity and gives rises to the theory of liquidity premium, which focuses on the benefits of holding cash (e.g., Lins at al., 2010; Palazzo, 2012). In former researches, discount effect of diversification hasn’t be strictly examined with the benefits of corporate liquidity. Thus, we contribute to the literature by further considering an essential operating factor, the corporate liquidity, to examine whether liquidity premium would mitigate the diversification discount effect and shed new light on the debate about the value of diversification.
For well over 20 years, researches have wrestled with the effects of corporate diversification on the value of the firm. A large body of corporate finance studies show the low valuation of diversified companies relative to their apparent breakup values (e.g., Lang and Stulz, 1994; Berger and Ofek, 1995; Comment and Jarrell, 1995; Servaes, 1996; Lins and Servaes, 1999; Lins and Servaes, 2002; Denis et al., 2002; Ammann, Hoechle, and Schmid, 2012; Chou and Cheng, 2012)1
1 Among these literatures, Lang and Stulz (1994) and Berger and Ofek (1995) find a significant diversification discount and interpret the results as evidence of value destruction by diversified firms.
Ammann, Hoechle, and Schmid (2012) report a robust and significant discount between 5% and 21%
for US nonfinancial firms between 1998 and 2005.
. Value
destruction by diversified firms relative to their focused competitors has been ascribed to many factors; among the most prominent of these explanations is that agency problems exacerbated by the diversified organizational form resulted in inefficient internal capital markets. However, the creation of internal capital market should be one of the motives of diversification. Theoretical models imply that cross-subsidization can be efficient; if it helps the firm to eliminate some of the costs of financial constraints. Nevertheless, several articles question the efficiency of internal capital markets and provide evidence of inefficient investment patterns, under which conglomerate firms operate an internal capital market that transfers cash flows inefficiently between business lines (e.g., Lamont, 1997; Shin and Stulz, 1998;
Lelyfeld and Knot, 2009; Ozbas and Scharfstein, 2010). For example, one possibility that has achieved considerable currency in the literature is the idea advanced by Berger and Ofek (1995); they suggest that headquarters may redistribute investment resources away from divisions with good investment opportunities, redirecting those resources to divisions with bad investment opportunities. Scharfstein and Stein (2000) demonstrate how the rent-seeking behavior of division managers can lead to inefficient cross-subsidization across divisions. Rajan et al. (2000) shows that a greater diversity of investment opportunities across segments leads to a greater misallocation of internal capital by diversified firms, due to power struggles between divisions. The negative impacts of corporate diversification are described in terms of other aspects of agency problems (e.g., Denis, Denis, and Sarin, 1997). Agency theory predicts that, regardless of actual investment efficiency from the shareholder perspective, diversification will typically be in the interests of management. At the firm level, empire-building preferences will cause managers to overinvestment and grow their firms beyond the optimal size. Specifically, managers have incentives to diversify their firms in order to increase their power, compensation and perquisites (e.g., Jensen, 1986;
Houston, James, and Ryngaert, 2001; Aggarwal and Samwick, 2003; Laeven and Levine, 2007). These motives can be associated with managerial hubris, managerial overconfidence, and executives’ pursuit of insurance to protect the value of their human capital.
The benefits of corporate diversification could arise from many sources advocated in theoretical literatures. Weston (1970) and Chandler (1977) suggests that diversified firms have the ability to use managerial economies of scale because they provide more efficient operations and more profitable lines of business when compared to stand-alone firms. Benefits of diversification also arise from the ability of diversified firms to internalize market failures (e.g., Khanna and Palepu, 2000) and from increased debt capacity as argued by Lewellen (1971). The positive impact of diversification can also be explained by the argument of multi-segment firms can do efficient resource allocation through internal capital markets (e.g., Stulz, 1990; Stein, 1997). Moreover, the recent research of Villalonga (2004) employs a more comprehensive database – the Business Information Tracking Series – and reports the result of a significant premium of diversification, rather than a discount. Several recent studies examine the value impact of diversification across the business cycle and conclude that corporate diversification becomes more efficient when external capital markets are relatively inefficient and when the various segments of a diversified firm would be financially constrained as single-segment firms (e.g., Dimitrov and Tice, 2006; Yan et al., 2010; Hovakimian, 2011). Overall, diversification enhances firm value by considering the synergy premium of factors such as greater operating efficiency, the presence of an internal capital market, greater debt capacity, and lower taxes.2
2Influential papers are Porter (1987), Ravenscraft (1987), Kaplan and Weisbach (1992), Bradley et al.
(1998), Fluck and Lynch (1999).
The main factor considering in our studies is the corporate liquidity. The benefits and costs associated with it are also extensively discussed in the prior literature. Much of the research on liquidity is framed around cash holdings, which means researchers use cash holdings for measurement of corporate liquidity (e.g., Kim et al., 1998;
Duchin, 2010; Lins at al., 2010; Denis, 2011). Why firms hold a large percentage of cash holdings in their assets in spite of associated opportunity cost can be related to three benefits. One predominant approach is referred as the precautionary motive for liquidity first introduced by Keynes (1936). It asserts that firms hold cash to protect themselves against adverse cash flow shocks that might force them to forgo valuable investment opportunities, because raising external finance is more costly than using internally generated funds in the presence of information asymmetry (e.g.,; Han and Qiu, 2007; Acharya, Almeida, and Campello, 2007; Haushalter, Klasa, and Maxwell, 2007; Harford, Mansi, and Maxwell, 2008; Bates, Kahle, and Stulz, 2009; Duchin, 2010).3 Another prominently cited benefit is the transaction cost motive, which suggests that firms hold cash because converting assets into cash entails transaction costs (e.g., Opler et al., 1999). They contend that in a world with significant transaction costs, the most obvious cost of holding liquid assets is the lower rate of return on these assets resulting from their “liquidity premium.” In other words, firms would rather hold liquid assets and entail opportunity costs because they value liquidity premium more than the costs of holding cash.4
3 The precautionary motive for cash savings is previously studied by Myers and Majluf (1984), Holmstrom and Tirole (1996, 1998), Opler et al. (1999), Mikkelson and Partch (2003), Almeida, Campello, and Weisbach (2004).
Recent theoretical research further explores the value of corporate liquidity. Gamba and Triantis (2008) argue that liquidity provides a firm with valuable financial flexibility. We can conclude the
4 For liquid assets held in the form of demand deposits, the opportunity cost increases with interest rates. To the extent that cash substitutes are deposited in short-maturity instruments, holding these cash substitutes becomes more expensive when the liquidity premium component of the term structure rises.
above three benefits as the liquidity premium hypothesis.
While cash can provide an operational flexibility to a manager, it can also make the firm vulnerable to managerial opportunism such as overinvestment (e.g., Myers and Rajan, 1998). As the costs of holding cash, free cash flow hypothesis is a long-cited theory that entrenched managers have a tendency to overspend their free cash flow on unprofitable projects for their own private benefits (e.g., Jensen, 1986; Stulz, 1990).
Firms would take into account the discretion and managerial opportunism associated with cash when choosing how to compose their liquidity reserves. Therefore, the negative effect of corporate liquidity on firm value is associated with agency problems considering factors of corporate governance (e.g., Yun, 2009). In general, the agency costs of managerial discretion are less important, and may be trivial for firms with valuable investment opportunities, because the objectives of management and shareholders are more likely to coincide (e.g., Opler et al., 1999).
In our research, our main purpose is to examine whether corporate liquidity premium would moderate the discount effect of diversification. As our proxy for measurement of corporate liquidity, besides cash holdings, we use net cash-to-assets ratio, which is defined as the ratio of cash and equivalents and short-term investments minus interest-bearing liability to total assets (e.g., Passov, 2003; Flannery and Lockhart, 2009; Islam, 2012). It conveys that firms which hold more net cash have the ability to satisfy a great number of future interest payments from debt with sufficient liquid asset balance on hand, hence to buy more time to exercise control over the firm’s policies without interference from creditors (e.g., DeAngelo et al., 2002). We consider net cash as a stricter proxy for the degree of liquidity than cash holdings which is traditionally used in literature because a high level of cash holdings is not equivalent to none debt holdings. There are at least two resources of cash holdings;
one comes from operating activities which is considered as unconditional liquidity
available in both good and bad times. The other resource is lines of credit, where the option to obtain cash can be exercised only when a firm is doing well enough to satisfy covenant restrictions (e.g., Sufi, 2009). Hence, net cash eliminates the effect from debt financing, and account for the cash purely accumulated from operating activities. In this paper, we regard net cash-to-assets ratio as a relatively representative proxy for corporate liquidity, and use both cash holdings and net cash to examine how corporate liquidity make influence on the adoption of diversification strategy to firm value.
The remainder of the paper is organized as follows. Section 2 develops two hypotheses about impact of the relation between firm diversification and corporate liquidity on firm value. Section 3 discusses the sample and describes the construction of variables. Section 4 presents the empirical model and the main results. Section 5 gives concluding remarks.