A Pure Financial Rationale for the Conglomerate Merger

Abstract

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Do financial conglomerates create or destroy economic value?

“…Most important, the three excess value measures are all significantly higher for focused than for diversified financial firms, which provides initial evidence of a diversification discount for financial conglomerates. Moreover, diversified firms are substantially larger (market value, sales, and assets), have higher leverage ratios (which is consistent with Lewellen, 1971), are less profitable (lower return on assets), and exhibit lower book-to-market and q ratios. Table 2 gives an overview of the number of sample firms for each calendar year, along with the number (and percentage) of focused and diversified firms.…”

“…Therefore, diversification seems to be value-decreasing only in firms with a high leverage ratio. 18 This result is somewhat surprising, since corporate diversification is argued to increase a firm's debt capacity and therefore lead to higher interest tax shields (e.g., Lewellen, 1971). In addition, it contradicts Jensen's (1986) free cash flow hypothesis.…”

Corporate mergers, stockholder diversification, and changes in systematic risk

“…This assumption may not, however, be sound. As Lubatkin and O'Neill (1987) point out, past studies have shown that mergers are often associated with increased debt levels (Melicher and Rush, 1974), or even motivated by increased debt (Lewellen, 1971). In addition, there is a positive relationship between a firm's debt level and its systematic risk (Hamada, 1972).…”

How firms manage their cash flows: an examination of diversification’s effect

“…This can arise because shareholders will be more credibly convinced to provide new capital when a firm's expected and realized cash flows are less likely to be significantly different. 2 Lewellen (1971) argues that the imperfect correlations between divisions' cash flows may increase debt capacity of firms by reducing the probability of default. 3 This leads us to posit: Hypothesis 1a.…”

“…Under this overinvestment hypothesis, diversified firms retain lower cash balances than specialized firms because they invest more of their operating cash flow. If operating cash flow is insufficient to cover investment then diversified firms can also raise external financing more easily than specialized firms (Lewellen, 1971;Stulz, 1990). 1 Our alternative hypothesis is that lower net cash flow in diversified firms is the outcome of larger or equal FCF relative to specialized firms.…”