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Does corporate diversification reduce value in high technology firms?

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Abstract

We find that firm value is reduced via industrial diversification and this reduction in value depends upon a firm’s technology intensity. We consider that asymmetric information problems are more severe in technology intensive industries and find that high tech industry firms present distinctly larger value reduction when compared to low tech industry firms. The negative valuation effect is greater for firms that have a relatively larger amount of intangible assets and greater R&D capital. We determine that our findings are robust to different estimation methods and alternative excess value measures.

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Notes

  1. The problems include endogeneity relations (Campa and Kedia 2002; Villalonga 2004a), selection bias (Graham et al. 2002), and measurement error (Whited 2001).

  2. Accounting rule makers argue that R&D is too uncertain to be treated as an asset (capital). This view is supported by Kothari et al. (2002) who determine that future earnings volatility is more strongly related with R&D expenditures than capital expenditures. However, some argue that U.S. GAAP prohibiting of capitalization of R&D expenditures for most industries causes investors to misvalue high tech firms. Lev and Sougiannis (1996, 1999) find that R&D capital is significantly and positively related with subsequent stock returns even after other fundamental factors are considered suggesting that R&D expenditures must be viewed as an amortizable asset rather than as expenses.

  3. Diversification may benefit managers by reducing the risk of their personal wealth portfolio (Amihud and Lev 1981), entrenching their positions within the firm (Morck et al. 1990), increasing their power and prestige (Jensen 1986; Stulz 1990), and increasing their total compensation (Jensen and Murphy 1990; Hyland and Diltz 2002). If these private benefits are greater than the managers’ private costs, then managers may even choose value-reducing diversification strategies. Based on these findings, several studies further investigate the relationship between diversification discounts and corporate governance (Jiraporn et al. 2006, 2008; Tsai et al. 2011; Nam et al. 2006; Hoechle et al. 2012).

  4. As discussed in Sect. 5 (Robustness), we also test after excluding all utility firms and find similar results.

  5. We also try other restrictions (e.g., 5%), and find similar results.

  6. We do not include single-segment firms with sales less than $20 million to avoid meaningless valuation multiples in the computation of imputed value for each segment.

  7. We also test the approximation of Tobin’s Q in Chung and Pruitt (1994) and find similar results.

  8. Our results remain the same when Tobin’s Q is not adjusted by the industry value.

  9. The co-insurance hypothesis, first presented by Lewellen (1971), suggests that diversification reduces the cost of debt. Lewellen (1971) argues that aggregating two or more firms that have imperfectly correlated cash flow streams reduces the variability of earnings for the combined firm. Lower variability of earnings would reduce the risk of default of the merged firms, thus increasing the debt capacity of the combined firm. Lewellen (1971) concludes that the increased debt capacity of the resulting firm, in combination with the effect of tax deductible interest payments (tax advantage), motivate shareholder wealth maximizing firms to engage in mergers. Higgins and Schall (1975) and Galai and Masulis (1976) later extend this co-insurance hypothesis and demonstrate, theoretically, that the co-insurance effect leads to an increase in the market value of the merging firms’ debt and a concomitant decrease in the market value of their equity. If diversification results in the co-insurance effect, lenders or bondholders are likely to reward it by accepting lower debt yields resulting in lower borrowing costs to the firm.

  10. Note that the differences in the tested variables should not be directly attributed to diversification due to an omitted variable problem in the analysis. Determining the right variables and examining whether diversification benefits are larger than costs are beyond the scope of this paper.

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Authors and Affiliations

  1. College of Business Administration, University of Wisconsin-La Crosse, 406F Wimberly Hall, 1701 Badger Street, La Crosse, WI, 54601, USA

    Nilakshi Borah

  2. Financial Research Institute of CCTV Securities Information Channel, B601 TYG Center, Chaoyang District, Beijing, 100027, China

    Liu Pan

  3. Muma College of Business, University of South Florida, 4202 E. Fowler Avenue, BSN3403, Tampa, FL, 33620, USA

    Jung Chul Park

  4. School of Finance, Henan University of Economics and Law, Jinshuidong Rd No. 180, Zhengzhou, 450046, Henan, China

    Nan Shao

Authors
  1. Nilakshi Borah
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  2. Liu Pan
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  3. Jung Chul Park
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  4. Nan Shao
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Corresponding author

Correspondence to Nilakshi Borah.

Appendices

Appendix 1

See Table 11.

Table 11 High tech and low tech industries
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Appendix 2

See Table 12.

Table 12 Comparisons of diversification benefits
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Borah, N., Pan, L., Park, J.C. et al. Does corporate diversification reduce value in high technology firms?. Rev Quant Finan Acc 51, 683–718 (2018). https://doi.org/10.1007/s11156-017-0685-2

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