Chasing Their Tails: Why Do Firms Subsidize Underperforming Business Units?

Abstract

Firms repeatedly fail to exit from underperforming lines of business. To explore the managerial motives of exit delay, this paper joins theory on scope economies and real options with a theory of internal capital market efficiency. I show that economies of scope, along with characteristics of the firm’s chief executive officer (CEO), play a significant role in the managerial decision to delay exit from an underperforming line of business. In the final stage of the analysis, I present evidence that managers may be overestimating the scope economies and option values behind their investment decisions, and that these decisions may also be subject to an escalation of commitment.