Effect of Diversification on Firms’ Value

Effect of Diversification on Firms’ Value

Introduction

In the 1950s and 1960s, a majority of corporate went the way of massive programs for diversification. The process continued until the 1960s when it reached its climax with the enormous rise to prominence of substantial conglomerate firms. That trend has, however, reversed in the past 15 years. The return to specialization replaced it. The push towards focus came as a result of the view that diversification that is unrelated leads to a decrease in the value of a firm. Arguments from theory argue that diversification, however, bears both value-reducing and value-enhancing effects. The benefits that could arise as a result of operating different business lines in a similar firm is the increase in operating efficiency, decreasing or low incentive of preceding the positive net present projects, the capacity of enormous debt, and lower taxes. However, there are potential costs that arise as a result of diversification, and they include the following; the employment of the diversification at the organizational workplace leads to the improved decision-making process, improved production value, and sharing of information. Therefore, diversification goes hand in hand with the firm’s value, and organizations should consider its employment when increasing a firm’s sustainability.

Review of related literature

The prior theory suggests that the effects of the performance of the diversification strategy of a firm depend on the capabilities and individual resources of the firm. It also depends on the setting that the firm operates in. Mackey et al. (2017), however, examined the relationship of average diversification-performance in all firms, as opposed to carrying out estimation on the link of diversification-performance at a firm’s level. The efforts for estimating the averaged relationship have consistency with the central assumption of more of strategic management theory. That is, firms frequently maximize value by selecting and choosing strategies that exploit their situation and heterogeneous resource. This study shows the fact that both diversified and focused firms tend to go for the diversification strategy, which maximizes value, whether the diversification is related, unrelated, or focus. It achieves that by adopting an approach which allows the evaluation of individual firms’ diversification-performance relationship.

` Xu et al. (2020) confirms the findings of Mackey et al. (2017) that firms seek value when they decide to diversify. Xu et al. (2020) show that extent by looking at the international diversification of the firms that are highly dominated by family. By drawing on the firm’s behavioral theory, the study sheds some light on the extensive debate concerning the willingness of family firms to diversify internationally. From the 93 countries analyzed between 2011 and 2018, it was clear that the diversification in the companies is different, and it explains the difference in their values.

Hanlon et al. (2019) create a hypothesis that prior evidence tax liabilities of target shareholder capital gains that affects the features of acquisition is driven by the target firm CEO’s tax liabilities. The study estimates the capital gains tax liabilities of CEOs for acquisition’s large sample and then examines such liabilities’ effects on the outcomes of purchase. Results indicate that the CEO tax effects drive the following; i) positive relations existing between tax rates of capital gains at a shareholder-level ii) acquisition premiums.
De la Fuente & Velasco (2020) investigates debt’s role as a governance mechanism that is internal, and that can be employed by firms or companies to curb discourage managers and agency conflicts from the diversification that destroys value. The study confirms the observation that such an effect arises from the monitoring role of debt fostering investment efficiency across segments and discouraging cross-subsidization.

Barbopoulos et al. (2018) examine earnout financing impact on the acquisition value of firms that engage in cross-border acquisitions (CBA). That is through the use of datasets from the following countries’ firms; US, UK, Canada, and Australia from 1992 to 2012. Results indicate that firms that initiate business operations that are international through CBAs financed by earnout improve value more than the acquirers in the two ways; domestic acquisitions and CBAs remaining by those multinational corporations which are already established. The study’s findings demonstrated earnout financing superiority in the CBAs that were announced by acquirers and that have had no business experience in the past. The investigation believes that earnouts play a significant role in reducing valuation risk that is faced by firms that acquire a firm with a foreign target.

One of the most debated topics in finance is corporate diversification in the last twenty years. While there is a belief that there is an existence of a discount in the valuation of the stock market of the conglomerates. Xiao, Z., & Xu (2019) argues the presence of empirical analyses do not emphasize some crucial features of data, primarily cross-sectional heterogeneity and that which have been predicted by casual corporate diversification’s observations and also by both theories. It thus does not give a whole picture of the discount’s diversification. With the use of a quantile regression analysis on the public firms of the U.S, the study carries out an investigation on heterogeneity importance on diversification, including other characteristics of other firms. Treatment effects, which are estimate quantile based, exhibit substantial heterogeneity, which was predicted.

Gyan. (2017) further investigates the inconsistencies of the performance of diversification link through the introduction of efficiency as a factor that is moderate. This study used data from 319 firms was used in conducting a panel data analysis, which excludes the industries in the financial sector, and the results demonstrate significant findings which include; For one, industrial diversification describes an essential contribution in the improvement of performance while diversification internationally shows no performance effect. That is despite international conglomerates showing a meaningful negative performance relationship. The study finds that efficiency is an essential factor in enhancing performance. However, it is not the moderating variable on the link of performance diversification.

Tsai. (2019) finds out the effects of intra-and inter-regional strategies of geographical diversification of the performance of firms in China. This study investigates the critical capabilities of firms, moderating the relationship between the performance of intra-and inter-regional geographic diversification. With the use of 366 listed companies with investments in China, the author discovers that there is a considerable influence of expansion contexts on the regional diversification effect.

Data and Descriptive Statistics

The data below shows the calculated Tobin’s Q from 1003-1988 to 1004-2007

The figure below shows in graph form the trend of Tobin’s q from 1003-1988 to 1004-2007

A summary of the Tobins’ Q calculations is shown below.

Replication of the required analysis

The firm needs investment money. The money could either be raised through borrowing or selling of shares or equity. When the firm sells the percentage, the buyer purchases shares to earn a capital gain from the improve share’s market value. From the tables above, there are instances where the q ratio is high, and other times it is low. When the q ratio is high, it means that the price of shares is also high. Therefore, the firm will need to invest more. For the calculated q ratios that are above 1, it indicates that the firm should buy physical capital or add the capital stock. In other words, when the q ratio is greater than 1, the firm will find it more profitable for the acquisition of additional capital since the capital value exceeds the cost for its purchase.

Conclusion

This paper offers a considerable contribution to the understanding of the implications of diversification. It demonstrates the evidence of curvilinear relation between excel value and diversification. Therefore, there exists an optimum diversification level in the sense that the strategy of diversification first develops or creates value; then, after a specific breakpoint, it destroys the value. Besides, in close relationship with the presumed relatedness benefits, this evidence offers support to the idea that diversification that is related to amount creates more value than the one that is not related. That suggests that diversification that is not associated with a relationship turns into a strategy that destroys value at levels that are lower than the diversification related to value does. In that case, relatedness creates a moderation to the discount value of firms that are diversified in accounting for the type of diversification’s moderating effect in its relationship with excess value. Operations in different units of business could develop and destroy a firm’s value according to the business operations’ similitude and value. Managers could benefit from the cycles of diversification by causing the movement of resources from segments in reaching the optimum to other sectors that are emerging until the beginning of a decline.

References

de la Fuente, G., & Velasco, P. (2020). Capital structure and corporate diversification: Is debt a panacea for the diversification discount?. Journal of Banking & Finance, 111, 105728.

Hanlon, M., Verdi, R. S., & Yost, B. (2019). CEO Tax Effects on Acquisition Structure and Value. Available at SSRN 3208223.

Mackey, T. B., Barney, J. B., & Dotson, J. P. (2017). Corporate diversification and the value of individual firms: A Bayesian approach. Strategic Management Journal, 38(2), 322-341.

Xu, K., Hitt, M. A., & Dai, L. (2020). International diversification of family-dominant firms: Integrating socioemotional wealth and behavioral theory of the firm. Journal of World Business, 55(3), 101071.

Tsai, H., Ren, S., & Eisingerich, A. B. (2019). The effect of inter-and intra-regional geographic diversification strategies on firm performance in China. Management Decision.

Gyan, A. K., Brahmana, R., & Bakri, A. K. (2017). Diversification strategy, efficiency, and firm performance: Insight from an emerging market. Research in International Business and Finance, 42, 1103-1114.

Xiao, Z., & Xu, L. (2019). What do they mean impacts miss? Distributional effects of corporate diversification. Journal of Econometrics, 213(1), 92-120.

Barbopoulos, L. G., Danbolt, J., & Alexakis, D. (2018). The role of earnout financing on the valuation effects of global diversification. Journal of International Business Studies, 49(5), 523-551.