Academic journal article Financial Management

Effects of Global and Industrial Diversification on Firm Value and Operating Performance

Academic journal article Financial Management

Effects of Global and Industrial Diversification on Firm Value and Operating Performance

Article excerpt

We directly test the impact of increases in global and industrial diversification on firm value and operating performance. Our sample represents 194 US firms that acquired foreign companies during 1985-1998. Announcement period returns are significantly positive for the acquirers. Acquirer firms with fewer growth opportunities, as measured by Tobin's q, create more value than do firms with more growth opportunities. Announcement-period returns and changes in operating performance are lower for firms that increase their global, industrial, or both forms of diversification.

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Reduced trade barriers, increased use of technology, and the relative benefits of operating overseas have all made it easier for US firms to expand overseas operations in the past two decades. But we know much less about the value of such global diversification than we do about the costs and benefits of industrial diversification. This gap motivates us to examine the stock price reaction and post-merger operating performance of US firms expanding internationally.

Several studies of global diversification focus on the cross-sectional relation between the firm's market value and the sum of the imputed values for its segments as stand-alone domestic entities. Bodnar, Tang, and Weinthrop (1998) apply this model to international acquisitions, and find that global diversification is associated with an increase in firm value. Denis, Denis, and Yost (2002) also use the imputed value method, but find that both global and industrial diversification reduce firm value.

Some researchers are skeptical as to the robustness of the imputed value method. Graham, Lemmon, and Wolf(2002) argue that findings based on it can be misleading. The excess value losses shown in such studies can arise because the sample firms have acquired companies that are trading at a discount when compared to their peers. Campa and Kedia (2002) and Villalonga (2004a) find that their sample of acquirers are already trading at a discount prior to the diversification.

In this paper we avoid these potential endogeneity problems and provide a more direct test of the impact of global and industrial diversification on firm value. We use the event-study method to examine the market reaction to acquisition announcements by US firms acquiring non-US firms. We analyze the long-term effects of these acquisitions by examining the operating performance of the acquiring firms during a three-year period after the acquisition. Our event study gives cross-sectional evidence around the announcement dates, and our examination of long-term operating performance provides evidence on the continuing consequences of the acquisitions.

Overall, we find positive and significant abnormal announcement-period returns for the acquirers. We find that these abnormal returns are lower for firms that increase global, industrial, or both forms of diversification. Abnormal returns are higher for cash acquisitions and lower when the target is located in a country with greater investor protection. Acquisitions by firms with fewer growth opportunities, which we measure by Tobin's q, create more value than those by firms with more growth opportunities.

To examine the operating performance of acquirers during a seven-year period around the acquisition, we use pretax operating cash flow scaled by the book value of assets as the measure of operating performance. We construct a control sample matched by firm size and performance and find that during the three-year period following the acquisition, our sample of firms performs at the same level as the control sample. A cross-sectional regression shows that changes in operating performance from pre- to post-merger are lower for the firms that increase their global, industrial, or both forms of diversification. We also find that announcement-period returns are positively related to operating performance changes, indicating that the market is able to anticipate some of the performance changes. …

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