Disentangling Value: Misvaluation and Divestitures

Working Paper No. 98017

47 Pages Posted: 28 Jul 1999

See all articles by M. P. Narayanan

M. P. Narayanan

University of Michigan, Stephen M. Ross School of Business

Vikram K. Nanda

University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics

Date Written: August 1998

Abstract

This paper presents a rationale for divestiture consistent with one of the frequently cited reasons by divesting firms, namely, that the firm is undervalued and splitting the firm into its component businesses will make it easier for the market to value the components accurately. The rationale is based on two basic premises. One, the market can observe the aggregate cash flows of the firm but not divisional cash flows; two, the cost of financing a project by divesting a division is greater than the cost of external equity financing which, in turn, is costlier than internal capital. In this setup, we show that the firm may be misvalued if the informativeness of divisional cash flows regarding the respective divisions' future prospects are different. If an undervalued firm needs external capital, it may resort to costly divestiture while an overvalued firm will use less costly external equity, resulting in correct valuation of the divisions. Among the empirical implications the model yields are: 1) The stock price reaction to a divestiture announcement is positive and is greater for focus-increasing divestitures; 2) Firms that divest invest more than their conglomerate counterparts; 3) Firms that divest are likely to divest the poorly performing divisions.

JEL Classification: G34

Suggested Citation

Narayanan, M. P. and Nanda, Vikram K., Disentangling Value: Misvaluation and Divestitures (August 1998). Working Paper No. 98017, Available at SSRN: https://ssrn.com/abstract=160970 or http://dx.doi.org/10.2139/ssrn.160970

M. P. Narayanan (Contact Author)

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States
734-763-5936 (Phone)
734-936-0274 (Fax)

Vikram K. Nanda

University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics ( email )

2601 North Floyd Road
P.O. Box 830688
Richardson, TX 75083
United States

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