Does the Trade-Off Theory Explain Debt Structure and Valuation for Divesting Parents in a Prosperous Australian Economy?

Abstract

This study examines the applicability of the trade-off theory to explain the valuation effects in response to divestiture announcements of Australian parents. It has been documented in the capital structure literature regarding various industrial and firm characteristics on motivation of the management to target optimal debt structure and leverage ratio accordingly. In the meantime, it has also been documented in the corporate restructuring literature regarding the impacts of leverage, such as the bankruptcy avoidance hypothesis, on motivation of the management to divest. For the sample of divesting parents in a generally prosperous state of the Australian economy in this study, empirical results support that there are significant differences regarding the valuation effects for parents at divestiture announcements between the high leverage sample and the low leverage sample. On the other hand, there are less significant differences regarding the valuation effects for parents at divestiture announcements between the increasing leverage sample and the decreasing leverage sample. The shareholders of highly leveraged parent companies consistently enhance their wealth more than their counterparts who hold equity in lowly leveraged parent companies in response to divestiture announcements. As such, the impacts of increasing leverage are different for highly levered firms from that for lowly levered firms.