The Value of Corporate Coinsurance to the Shareholders of Diversifying Firms: Evidence from Marginal Tax Rate

Abstract

We test whether conglomerate mergers produce higher gains to shareholders due to corporate coinsurance than horizontal mergers by comparing the wealth change to shareholders around merger announcement. Conglomerate mergers show higher size-weighted average of bidder and target marginal tax rates than horizontal mergers. The higher marginal tax rates in conglomerate mergers provide extra returns to combined shareholders which vary from 0.23% to 0.46% according to model specification of coinsurance benefit to combined shareholders. We further investigate the change in financial leverage and cash holdings after merger completion to find the channel through which diversified firms make the most of higher marginal tax rates in comparison of specialized firms. The higher marginal tax rates help the consolidated firm to reduce cash holdings but do not have an impact on the leverage change after merger completion. Other coinsurance determinants such as sash flow correlation and volatility difference do not affect the change in subsequent change in both financial leverage and cash holdings. Our test results indicate that diversifying mergers of high bidder and target marginal tax rates enhance the stock value of both bidder and target firm around merger announcement and diversified firms realize this coinsurance benefit by reducing cash holdings rather than increasing financial leverage.