Cannibalization Risk and Limited Liability: Implications for Firm Valuation and Capital Budgeting

41 Pages Posted: 16 Dec 1996

See all articles by Domingo Joaquin

Domingo Joaquin

Illinois State University - Department of Finance, Insurance and Law

Naveen Khanna

Michigan State University

Date Written: October 1996

Abstract

Limited liability is valuable because it provides equity holders the option to exit when faced with negative cash flows. However, when two firms merge, it is less likely that the aggregate cash flows will be negative since the negative cash flows of one firm may be offset by the contemporaneous cash flows (if positive) of the other firm. This reduces the value of the exit option. This loss in value translates into a gain to stakeholders with fixed contractual arrangements with the individual firms. To the extent that equity holders are unable to recover these gains (transfers), they are worse off by merging. This may at least partly explain recently documented observations that there is value loss from diversification, value gain from splitting up an existing firm, and that the value loss is higher in the case of diversification into unrelated industries. It may also explain why Tobin's q of a merged firm may be lower than the weighted average of the q's of its individual units as independent firms. In addition, because the negative cash flows of some projects can cannibalize the positive cash flows of other projects, the value and riskiness of an identical project will be different for firms with different assets-in-place. Thus, the value of a project as stand alone may be irrelevant for a firm's investment decision. When extended to a dynamic setting, the possibility of cross- cannibalization generates additional real effects by impacting the investment timing decision of firms differently depending on their existing assets. For instance, when a firm invests in a project in an unrelated industry, its entry and exit decisions differ from that of a firm in the same industry as the project. This results in a higher value loss for the firm entering the unrelated industry both because of higher cannibalization risk and of the differential impact on investment timing.j

JEL Classification: G31, G34

Suggested Citation

Joaquin, Domingo and Khanna, Naveen, Cannibalization Risk and Limited Liability: Implications for Firm Valuation and Capital Budgeting (October 1996). Available at SSRN: https://ssrn.com/abstract=1737 or http://dx.doi.org/10.2139/ssrn.1737

Domingo Joaquin (Contact Author)

Illinois State University - Department of Finance, Insurance and Law ( email )

Normal, IL 61790
United States
(309) 438-2258 (Phone)
(309) 438-5510 (Fax)

Naveen Khanna (Contact Author)

Michigan State University ( email )

East Lansing, MI 48824-1121
United States
517-353-1853 (Phone)
517-432-1080 (Fax)

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