Disentangling Value: Misvaluation and Divestitures

Abstract

This paper presents a rationale for divestiture consistent with one of the frequently cited reasons by divesting firms, namely, that the firm is undervalued and splitting the firm into its component businesses will make it easier for the market to value the components accurately. The rationale is based on two basic premises. One, the market can observe the aggregate cash flows of the firm but not divisional cash flows; two, the cost of financing a project by divesting a division is greater than the cost of external equity financing which, in turn, is costlier than internal capital. In this setup, we show that the firm may be misvalued if the informativeness of divisional cash flows regarding the respective divisions' future prospects are different. If an undervalued firm needs external capital, it may resort to costly divestiture while an overvalued firm will use less costly external equity, resulting in correct valuation of the divisions. Among the empirical implications the model yields are: 1) The stock price reaction to a divestiture announcement is positive and is greater for focus-increasing divestitures; 2) Firms that divest invest more than their conglomerate counterparts; 3) Firms that divest are likely to divest the poorly performing divisions.