Corporate Diversification and Credit Risk

32 Pages Posted: 13 Mar 2008

See all articles by Hsien-Hsing Liao

Hsien-Hsing Liao

National Taiwan University

Tzu-Ling Huang

affiliation not provided to SSRN

Date Written: June 2007

Abstract

Existing literature has documented a lot of research efforts on the issues of corporate diversification discount and diversification premium, most of them trying to explain the rationales why firms diversify or focus, especially to unveil the benefits and costs of their diversification decisions. However, few of them explore the relationship between corporate diversification and corporate credit risk. It is the purpose of this study to investigate the effects of corporate diversification on both credit risk and firm value using American firms engaged in mergers and acquisitions from 1980 to 2005. In this study, we calculate a firm's one year default probability according to Black-Scholes (1973) and Merton (1974) and we follow both Berger and Ofek (1995) and Mansi and Reeb (2002) to calculate the excess firm values. We obtain several interesting findings. First, we observe that according to levels of credit quality, the changes in default probability move in different directions when firms diversify. Default probabilities of risky firms decline when diversifying, which is consistent with coinsurance effect and risk effect, while, on the contrary, those of safe firms increase, which violates the hypothesis of coinsurance effect. It can be explained by a strong risk effect suggested by Billett, King, and Mauer (2004). Second, market values of equity move in the same direction with default probabilities. It is consistent with the option theory based credit model originated by Black-Scholes (1973) and Merton (1974). We find that risky firms bear diversification discount and safe firms enjoy diversification premium when we only consider the wealth changes of stockholders. Finally, we provide empirical evidences for wealth transfer effect and show that the directions of the transfer are opposite according to the credit quality of diversifying firms.

Keywords: diversification, credit risk, wealth transfer, coinsurance effect, risk effect

JEL Classification: G39, G34

Suggested Citation

Liao, Hsien-Hsing and Huang, Tzu-Ling, Corporate Diversification and Credit Risk (June 2007). Available at SSRN: https://ssrn.com/abstract=1099803 or http://dx.doi.org/10.2139/ssrn.1099803

Hsien-Hsing Liao (Contact Author)

National Taiwan University ( email )

1 Sec. 4, Roosevelt Road
Taipei, 106
Taiwan

Tzu-Ling Huang

affiliation not provided to SSRN

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