The Impact of Corporate Diversification on the Option Value of Equity

Abstract

This article quantifies the effect of risk-reducing corporate diversification on the option value of equity using contingent claims analysis. The impact of conglomeration on firm risk is heavily conditioned on firm size. In contrast to small firms, the risk of large firms does not decline with increasing conglomeration. Accounting for this effect, the expected equity discount is much lower than commonly assumed and can even turn into a premium if the path dependency of equity is incorporated. These results stand in direct contrast to those of Mansi and Reeb (2002) and caution against using asset substitution as a qualitative argument for explaining broad economic phenomena involving shareholder value.

Keywords: Contingent-claims analysis, Corporate Diversification, Risk-Shifting

JEL Classification: G13, G31