Conglomerate Discount: A New Explanation Based on Credit Risk

Posted: 19 Jul 2007  

Manuel Ammann

University of St. Gallen - School of Finance

Michael Verhofen

University of St. Gallen - Swiss Institute of Banking and Finance; Allianz Global Investors

Abstract

We present a simple new explanation for the diversification discount in the valuation of firms. We demonstrate that, ceteris paribus, limited liability of equity holders is sufficient to explain a diversification discount. To derive this result, we use a credit risk model based on the value of the firm's assets. We show that a conglomerate can be regarded as an option on a portfolio of assets. By splitting up the conglomerate, the investor receives a portfolio of options on assets. The conglomerate discount arises because the value of a portfolio of options is always equal to or higher than the value of an option on a portfolio. The magnitude of the conglomerate discount depends on the number of business units and their correlation, as well as their volatility, among other factors.

Keywords: Conglomerate, diversification, discount, credit risk, limited liability

JEL Classification: G13, G32, G33, G34

Suggested Citation

Ammann, Manuel and Verhofen, Michael, Conglomerate Discount: A New Explanation Based on Credit Risk. International Journal of Theoretical and Applied Finance, Vol. 9, No. 8, pp. 1201-1214, 2006. Available at SSRN: https://ssrn.com/abstract=1000170

Manuel Ammann (Contact Author)

University of St. Gallen - School of Finance ( email )

Unterer Graben 21
St.Gallen, CH-9000
Switzerland

Michael Verhofen

Allianz Global Investors ( email )

Frankfurt
Germany

University of St. Gallen - Swiss Institute of Banking and Finance ( email )

Rosenbergstrasse 52
St. Gallen, CH-9000
Switzerland

HOME PAGE: http://www.verhofen.com

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