Academic journal article Financial Management

Excess Cash Flows and Diversification Discount

Academic journal article Financial Management

Excess Cash Flows and Diversification Discount

Article excerpt

We study the impact of diversification on firm cash flows and excess value. Specifically, we investigate whether there is a direct link between the discount to diversification and excess cash flow reductions around related and unrelated acquisitions. Our results provide empirical support for a positive and significant association between excess cash flow declines and excess value losses after the acquisition. Our findings also show that bidders who conduct unrelated acquisitions experience larger excess cash flow declines and valuation discounts than do bidders who engage in related acquisitions. Our results are robust to the targets' excess cash flow and valuation characteristics.

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Recent empirical studies find that the average diversified firm trades at a discount relative to a portfolio of comparable single-segment firms. This literature suggests that diversification itself might be the reason that diversified firms produce cash flows different from those they would generate if broken into single-segment firms operating in the same line of business with diversified firm's distinct lines of business (see Berger and Ofek, 1995 among others). (1) The possibility that conglomeration might reduce cash flows motivates this article. However, several papers (Campa and Kedia, 2002; Chevalier, 2000; Graham, Lemmon, and Wolf, 2002; Whited, 2001; and Villalonga, 2004a, 2004b) in one way or another are skeptical about the diversification discount. Moreover, Mansi and Reeb (2002) show that the measure of excess value, as developed by Lang and Stulz (1994), and Berger and Ofek (1995), creates a downward bias in diversified firms, because it captures only the shareholder value of the firm. They argue that diversification reduces firm risk and, therefore, it does not have adverse bearing on the cash flows of the firm. However, they do not provide evidence in support of this conjecture. While the Lamont and Polk (2001) study, based on aggregate data, shows that firm value is inversely related with subsequent returns and that the diversification discount manifests itself in both expected returns and expected cash flows, it does not provide direct evidence in support of a link between firm cash flows and excess value.

If the value of the firm is the discounted value of its cash flows and if there is a discount to diversification, then the discount should be either because cash flows decline, or the discount rate rises with diversification. In this article, we examine the impact of diversification on firm cash flows and excess values and investigate whether there is a direct association between changes in cash flows and the diversification discount (i.e., excess value) around the act of diversification, (2) We examine this relation for multi-segment firms that engage in related and unrelated acquisition transactions and compare their differences. We also analyze the impact of targets on the bidders' excess cash flows and diversification discount. To address these issues, we use a sample of 742 firm-year acquisitions completed by US firms over the 1991-1997 period.

Our results provide empirical support for a positive association between reductions in cash flows and changes in the diversification discount subsequent to acquisitions. Our findings show that a 10% decline in bidders' excess cash flows is associated with a 3.7% excess value loss. Second, we find that bidders that acquire unrelated targets experience greater excess cash flow declines and valuation discounts than do bidders involved in related acquisitions. Third, our results are robust to the targets' excess cash flow and valuation characteristics. Finally, our evidence indicates that industrial diversification is driven by bidders' industry growth opportunities.

The article proceeds as follows. Section I describes our data sources, sample selection procedure, and sample characteristics. Section II presents the pre-acquisition excess cash flow and valuation performance of bidders. …

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