Divestitures and Divisional Investment Policies

We study a sample of diversified firms that alter their organizational structure by divesting an entire business segment, primarily through asset sales. These firms experience a substantial reduction in the diversification discount after the divestiture. Investment in the firm’s ongoing segments is more sensitive to their imputed market to book ratio. We show that the efficiency of segment investment increases substantially following the divestiture and that improvement in the efficiency of investment is associated with a decrease in the diversification discount. Our results support the corporate focus and financing hypotheses for corporate divestitures. We conclude that inefficient investment is partly responsible for the diversification discount and show that asset sales lead to an improvement in the efficiency of investment for remaining divisions. Divestitures and Divisional Investment Policies It is well known that diversified firms trade at a discount relative to stand-alone firms. However, there is debate over the cause of the discount. A commonly held view is that inefficient investment policies of diversified firms are to blame for the diversification discount. For instance, Lamont (1997) suggests the inefficient investment hypothesis by showing that diversified oil companies cut back on investment in non-oil divisions when oil prices declined during the 1980s. Shin and Stulz (1998) find that divisional resources do not appear to be directed to segments with the most favorable investment opportunities. Scharfstein (1998) shows that misallocation of resources between divisions is most pronounced when management has a small ownership stake and suggests that agency costs underlie distortions in divisional allocation. Most of the existing literature uses cross-sectional comparisons of diversified firms to investigate the discount and the investment policy. This approach has been the source of much of the debate about the diversification discount. Our approach, in contrast, is to examine changes in the degree of diversification for firms and test whether changes in diversification are associated with simultaneous changes in the diversification discount and investment policy. We then explore several hypotheses to explain the changes in the discount and investment policy. The primary advantage of this approach is that it does not rely on cross-sectional comparisons of the discount across firms and thus avoids the omitted variables problem that typically confounds inferences from this research. A number of recent papers describe the potential problems with cross-sectional comparisons of the discount. For example, Maksimovic and Phillips (2001) argue that the choice to diversify is endogenous and that the discount reflects underlying firm characteristics that explain which firms diversify. Similarly, Burch, Nanda, and Narayanan (2000) contend that the choice to diversify is an 1 Berger and Ofek (1995, 1996), Lang and Stulz (1994), Servaes (1996), Denis and Thothadri (1999), Lamont and Polk (2002a), among others, document the discount of diversified firms relative to stand-alone firms. There has also been a systematic pattern of firms undoing diversification in recent years, as shown by Comment and