Wealth Transfer or Wealth Destruction: Does Contingent-Claims Analysis Justify a Diversification Discount?

Abstract

Using US stock market panel data from 1984 to 2005, I examine the relationship between diversification effects predicted by the classic Merton (1974) model of capital structure on the one hand and the conglomerate discount resulting from comparable company analysis as initially proposed by Berger and Ofek (1995) on the other. Improving upon previous research, I explicitly calculate a measure for the predicted discount on equity values by means of contingent-claims analysis, accounting for the risk reduction induced by firm-level diversification. This allows me to provide an estimate for the wealth transferred from shareholders to bondholders via ''reverse asset substitution''. Relying on both, plain vanilla and barrier option pricing, I show that for the majority of firms in the sample, the wealth transfer is much lower than commonly expected. The negative relation between leverage and the value of conglomerates found by Mansi and Reeb (2002) and confirmed in my study appears to be an artifact of model design. On a more general level, my results caution academics and practitioners alike against using risk-shifting as a qualitative argument for explaining economy-wide phenomena of shareholder value creation or destruction.