Investment Opportunities, Liquidity Premium, and Conglomerate Mergers

Abstract

In this article we show that in a finitely liquid market with asymmetrically informed investors, both the benefits and the costs of diversification vary with the return and risk of the investment opportunities of the firm's divisions. The benefits come from a reduced liquidity discount in the stock price of the merged firm when its shareholders anticipate less informed trading. The costs are the result of less efficient investment by the merged firm's divisions due to a less informative stock price. Our results provide explanations for the life cycle of diversification strategies and implications for evaluating merger and spin-off candidates.

Keywords: mergers and spinoffs, corporate diversification and focus, security design, allocative information, liquidity

JEL Classification: D82, G34, L22