TERM PAPER

EFFECT OF DIVERSIFICATION ON FIRM VALUE

IRENE TIURMA SIAGIAN

1.0 INTRODUCTION

Corporate diversification reveal both benefits and costs to a company. Company can benefit from diversification through the creation of internal capital markets (Williamson, 1970), higher debt capacity (Lewellen, 1971; Shleifer & Vishny, 1992) and economies of scope (Teece, 1980). Meanwhile, the costs of diversification stem mainly from agency problems. Managers may diversify to protect their human capital (Amihud & Lev, 1981), to increase their private benefits (Jensen, 1986; Morck et al., 1990), or to entrench themselves (Shleifer & Vishny, 1989). Within a diversified firm, managers may have easy access to capital through cross subsidization (Meyer et all., 1992), which may lead to over-investment (Jensen, 1986; Stulz, 1990; Berger & Ofek, 1995).

Recent literature shows that corporate diversification strategies are associated with significant value loss and that increasing corporate focus is value-enhancing. Examples of these studies include Lang and Stulz (1994), liebeskind and Opler (1994), Berger and Ofek (1995, 1996), Comment and Jarrell (1995), John and Ofek (1995), Servaes (1996), and Denis et. Al. (1997). The evidence in thse studies suggests that the costs of diversification outweigh the benefits. Given the extensive evidence that diversification is associated with a reduction in firm value.

Even firms in the developing countries inclusive Malaysia, international diversification had gradually become integral part of the business growth strategy since the late 1980s.

2.0 INTERNATIONAL DIVERSIFICATION and INDUSTRY DIVERSIFICATION

Based on this theory, firms can exploit new foreign markets by leveraging on its existing assets (tangible and intangible) to synergize the operations efficiently (Dunning and Rugman, 1985; Rugman, 1977). Specific advantage for the firm it can efficiently “internalize” or transfer the value of foreign assets into the firms’ assets at home country, and thus reduces the risks and costs associated with their international diversification efforts (Caves, 1971). Another scholars, suggested that intangible assets are important in creating value through international diversification effort.

Industrial diversification is a strategy that involves choosing to structure a company operation in a manner that promotes involvement in a wide range of revenue producing activities. An approach of this type may have to do with the production of goods and services associated with the business, or may focus more on how the company chooses to arrange its investment portfolio. The goal of any type of industrial diversification is increase the chances of returns by diversifying or spreading assets over a wider range of activities, while also helping to minimize the potential for failure or loss.

3.0 MAIN THEORETICAL CONTRIBUTIONS

4.1 Agency Theory
This theory predicts that regardless of actual investment efficiency from the shareholder perspective, diversification typically will be in the best interests of management. Specifically, managers have incentives to diversify their firms to (a) increase their power, compensation and perquisites (Jensen1986; Jensen and Murphy 1990; Stulz 1990), (b) reduce their individual employment risk that is closely related to firm risk (Armihud et al. 1981) and (c) to entrench themselves (Shleifer and Vishny 1989).

4.2 Theory of Internal Capital Markets
The creation of internal capital is the most important motives of diversification. Mostly used as collateral for obtaining funding for other segments, or to be used to subsidize investment in other division of the firm. Implied pro and con, this cross-subsidization can be efficient if it helps the firm eliminate some of the costs of financial constraints or it may be inefficient if the firm underinvests in divisions with greater with better growth opportunities and overinvests in those with worse prospects.

4.3 Debt Co-Insurance Effect
A combination of different businesses, with imperfectly correlated cash flows, reduces overall firm risk and thereby decreases the probability of insufficient debt service. This is so-called debt co-insurance leads to a higher (potential) debt capacity and other way to gains in firm value, through an increased tax shield, due to substitution of equity with debt capital.

4.4 Value-Maximizing and Dynamic Models

Matsusaka (2001) describes diversification as dynamic matching process for a firm’s organizational capabilities. The process to do diversification is characterized as uncertain and only be done through experimenting. Gomes and Livdan (2004) develop a dynamic model of optimal corporate behaviour in which diversification is a value-maximizing response to increasing firm age and growth. Firm diversify for two main reasons, first when the firm has become less profitable, and second able to bring down fixed costs of production and eliminate redundancies across different activities.

4.5 Corporate Refocusing Theory
This assume that diversified firms trade at a discount, relative to what those firms would be worth if they were split up. The value of diversification here will depend on whether the potential costs outweigh the potential benefits, or vice versa.

4.0 SINGAPORE SCENARIO

Based on a studies made by S.S Chen and K.W Ho (2000)Singapore provides an interesting setting to examine corporate diversification because it has a small and open economy. Singapore firms may need to diversify because of the small size of the market. Further, Singapore’s capital market are not as developed as those in the US and other developed economies. The lack of depth in the capital markets suggests that there may be beneficial effects from diversification due to a more efficient internal capital market. Finally, ownership structure in Singapore firms and its effect on corporate diversification may be different from those in the US.

Based on Denis et al. (1997) show that larger firms are more diversified than smaller firms. S.S Chen and K.W Ho (2000) found that level of diversification is negatively related to outside blockholder ownership, but is unrelated to insider ownership, has a contradicted findings with Denis et.al. (1997) found that both managerial and outside block ownership are effective deterrent to corporate diversification. Based on this studies also show that the multi-segment firms have lower firm value than single-segment firms. Further based on this studies, the value loss from diversification is significant only for firms with low managerial ownership where that agency problems are more severe for firms with low managerial ownership. However evidence in Denis et al. (1997) is contrast where managerial ownership does not have a significant impact on the value of diversification. Both studies found that outside block ownership does not have a significant impact on firm value.

S.S Chen and K.W Ho (2000) has a consistent findings with Lang and Stulz (1994) where the degree of diversification has a negative impact on firm value. The findings find no correlation between insider ownership and the level of diversification and a weak negative relation between outside block ownership and diversification. Singapore capital market scenario is different with US, as Singapore scope of market is small and less developed and it is wisely for firms to create an internal capital market by diversification. It is found that there is similarity with US market and Singapore market where diversified firms are valued less than single-segment firms. However this only for those firms with low insider ownership. This is consistent due to agency cost explanation that managers with lower ownership stakes in their firms have more incentives to pursue value-reducing diversification than those with larger stakes, this happen as private benefits may outweigh the value loss from diversification. Thus Singapore managers should be given more stakes in their firms. Although there is a recent study by Yeo et al. (1999) executive share option that can be offered is limited under ESOPs while the government recognize this problem and relaxed the rule to allow able to issues more share under ESOP’s more than 5%.

5.0 Malaysia Scenario

Based on K.T Lee and C.W Hooy and G.K Hooy (2012), this study indicates there are no evidence that international diversification has significant impact on firm value and industry diversification only give a slightly increase in firm value. This research further indicates without any diversification, family ownership presents lower value than foreign and government ownership, while industrial diversification family ownership presents significant higher value than foreign and government ownerships.

Modighani-Miller theorem via its irrelevancy propositions, there should not be any impact on valuation due to firm’s major corporate decisions. However most CEOs’ around the world ignoring this theorem including in Malaysia. Malaysia started venturing into international business as early of 1970s and continue to growth with the impact of economic changes and the formation of AFTA Goh and Wong (2011). Based on Lins and Servaes (2002) indicates that 47% of Malaysian firms were diversified and Malaysia was the most diversified country among the seven East Asian countries.

The main forces driving diversification in emerging countries is the support level from the external capital market and more companies are relying internal capital markets for sources of funding.

Claessens et al. (2006) found that most commonly business affiliated group in East Asian countries where a number of firms belong to a share ownership entity through pyramiding and crossholdings which can help to create internal capital market. This funds is allocated among firms within the group to facilitate any investment and financial needs which perceived to bring future benefits to the firms.As evidenced in previous literature, agency costs associated with ownership structure must be taken into account since it might have correlation with firm value (e.g.,Claessens et al., 2002; Demsetz and Lehn, 1985; Denisetal.,1997;Fauveretal.,2003,2004; McConnelland Servaes,1990; Morcketal.,1988; LinsandServaes,1999). To ascertain extent, ownership structure could dictate the value of corporate diversification.

Incorporate ownership identity which has been proven to have influence on firm valuation in previous literatures. or example, government firms could have higher performance as the management is more alert about improving firm value under the watchful eyes of the government and the public (Lau and Tong, 2008). However, these firms could perform poorer than other firms as they have social responsibilities (Sulong and Mat Nor, 2008). Second, when the owner is a foreign investor, firms could have better valuation as the owner is most probably capable of injecting capital and transferring managerial expertise and technology from their country to the firm (Sulong and Mat Nor, 2008), however this type of firms could also lead to poorer firm value as the owners are facing difficulties in monitoring the firms when they are not staying at the country where the firms are located (Wiwattanakantang, 2001). The hiring of professionals who have no shareholdings in running the business might not be guaranteed for profit maximization goals (Kim and Lyn, 1990).

K.T Lee and C.W Hooy and G.K Hooy (2012) reveals that international diversification does not significantly affect firm value in Malaysia. However, industrial diversification able to enhances firm value. Further this studies find that domestic/focused firms, family ownership presents significant lower value than foreign and government ownerships, suggesting that these family-controlled firms are resource poor as stand-alone units as compared to foreign and government owned firms that possess stronger financial resources.

However, for domestic conglomerates, family ownership indicates significantly higher value than the foreign and government ownerships. This posits to smooth reallocation of money among investment projects through the internal capital market only of family-controlled business group firms works well in Malaysia.

It is suggesting that government-owned firms may have the incentives to diversify, but they lack motivation and/or expertise in managing the growth and complexity in the conglomerate settings. Suggesting the same with foreign owners could be facing difficulties in understanding the local business diversification complexity, structure as the firms become diversified.

Lee and Kian Tek (2013) found results show that international diversification reduces firm value, but industrial diversification enhances it. The studies suggested that ownership identity affects firm value which stated that foreign-owned firms significantly reduce the discount on firm value relative to government and family-owned firms in the context of international diversification. Whereby if investigating each industry separately, diversification impacts on firm value reveal slight different results; suggestions show that international diversification actually enhances the firm value for consumer product and plantation industries, and industrial diversification reduces firm value for plantation industry.

These results may imply that the potential benefits of investing overseas are not fully utilized or materialized by the Malaysian firms. Or due to the costs of investing in international market outweight those benefits. While it is suggest that the reason for industrial diversification enhance the value of firm maybe due to the fact that they are generally involved in businesses within their related core competencies.

By looking at ownership structure, the finding show that multinational firms continue to trade at a discount, while multi-industry firms trade at a premium. These show ownership structure generally does not significantly affect the firm value. However one ultimate finding claim that foreign ultimate ownership can help firms in Malaysia to enhance the firm value. It were suggested this due to when a foreign ownership in a firm will smoothen the process of forming a strategic partnership in the international market through global networking and expertise and will lead to value creation for the firm.

This finding also demonstrate that diversification effect on firm value also has different relationship based on whether the firm is in the core industry in Malaysia. If it is in the core industry it will give a positive relationship or otherwise. Also firm that diversify to other industry must be related to their core industry in order to increase their firm value.

6.0 International Evidence

Based on studies by Stephen P, Nilanjan S and Nguyen T (2010), by examining 12,000 firms across 35 emerging and developed countries excluding US during the period 1991-2006 suggesting that either alone or combined between industrial diversification and global diversification, results in a reduction of firm excess value. While global diversification alone does not exert a significant impact on excess value.

The findings of this studies demonstrated that larger firms are more likely to operate across multiple business lines or national market. And firms that facing with poor profitability and growth opportunities are more likely to persue diversification. Besides that firms with high degree of leverage more engage to industry rather than global diversification. Along with that firm with high liquidity are more likely to be globally rather than industry diversified. Firm with low levels of R & D expenditures are more likely to be industrially diversified whereby firm with high levels of R& D expenditure are more likely to be globally diversified. Another interesting findings shows that countries which applied civil laws are more likely to engage in diversification compare with common law countries.

7.0 Overall Outlook

In the last decade, based on prevailing studies and literatures has suggested that strategy of diversification of firm cause a trade at a discount for example Lang and Stulz 1994; Bergeer and Ofek 1995. Which assuming diversification only bring down value of firm and not an efficient way. However it still a common corporate strategy. Other studies suggesting that firm value can differ from one firm to another different firm and depending on industry setting and economic environments for example Santalo and Becerra (2008) argue the effect of corporate diversification are heterogeneous among industries which means some may create higher value to the firms and some might trade in discount. Several recent studies instead found that there should be a dynamic change in the diversification discount or premium over time based on business cycle and conclude that the corporate diversification becomes more efficient during recession or in other words when external capital markets are relatively inefficient. In this situation the diversified firms will be benefited with their internal capital markets for example Kuppuswamy and VIllalonga (2010).

8.0 Biases in the Valuation

Nowadays, questioned arise whether a discount really exist in firm value due to diversification or it happens because of certain items. The reasons suggested first, the diversified firms are already discounted prior to acquisition and explanations from Mitton and Vorkink (2010), argue that stock returns for diversified firms have lower variance and skewness than stock returns of single-segment firms thus require higher average returns for the lack of skewness (upside potential).

Second, diversification made is not randomly but normally on information observed by the firm. Heckman approach to control endogeneity of the diversification decision results indicate diversification does not discount firm value but contrast with Lamont and Polk (2002) provide evidence that supports the diversification discount even after controlling for the endogeneity of the firm’s decision to diversify. They find that exogenous changes in corporate diversity are negatively related to firm value and conclude that diversification reduces firm value.

Third, most of the empirical studies are based on COMPUSTAT segment data. However the usage of this data bring several important concerns such as Lichtenberg (1991) disaggregation in COMPUSTAT segment data is lower than the true extent of firm diversification. Other, Hyland and Diltz (2002) find many segment by COMPUSTAT are mere reporting changes and do not represent actual diversifying events. Hence, as argued by Villalonga (2004) by using COMPUSTAT segment data the data processed might be bias.

9.0 Two Sides of Coin: Endogenous and Exogenous Effects

An interesting findings towards firm value with the impacts applying diversification by looking into two elements; endogenous and exogenous effects by Xi He (2012). Based on this studies, an unexpected increase in diversification caused by exogenous shocks will destroys firm value while an endogenous increase in diversification due to managerial decisions will enhance firm value, means a diversification premium from altering organizational structures.

Lamont and Polk (2002) study the causal effects of diversification, they found that both exogenous and endogenous changes in diversification are negatively correlated with firm value but they cannot identify a causality rather than correlation between diversification and firm value.

Xi He (2012) findings consistent with Lamont and Polk (2002), suggesting exogenous increase in diversification reduces firm value. Meanwhile, in contrast, an endogenous increase in diversification enhances firm value, indicating a diversification premium for firms choose to alter their organizational structures. These two findings are not mutually exclusive, the exogenous changes in outside economic conditions affect firm value through diversification mechanism, then the firm simultaneously observe such negative shocks, they can endogenously change their organizational structure to take the benefits of diversification which will enhance firm value back. This supporting Gomes and Livdan (2004) who argue that diversification is optimal for diversified firms even though they are selling at a discount. Although those diversified firms valued at a discount would have been valued even much lower if diversifying never taken into action.

References

Lee, Kian-Tek (2013). The value impact of international and industrial diversification on Malaysian firms: firm-level and industry-level analysis. The IEB International Journal of Finance 7 (2013), 128-147

Stefan, Thomas H., Nicolas H, Michael M (2013). Corporate diversification and firm value: a survey of recent literature. Swiss Society for Financial Market Research 27 (2013), 187-215

Stephen P, Nilanjan S and Nguyen T (2010). Firm value and the diversification choice: International evidence from global and industrial diversification. Applied Economic Letters 17 (2010), 1027-1031

S.S. Chen, K.W. Ho (2000). Corporate diversification, ownership structure, and firm value The Singapore evidence. International Review of Financial Analysis 9 (2000), 315-397

Xi He (2012). Two Sides of a Coin: Endogenous and Exogenous Effects of Corporate Diversification on Firm Value. International Review of Finance 12:4 (2012), 375-397