Posted: 19 Jul 2007
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: 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