Firm diversification and the value of corporate cash holdings

This paper studies the effect of firm diversification on the value of corporate cash holdings. We develop two hypotheses based on efficient internal capital market and agency problems. We find that the value of cash is lower in diversified firms than in single-segment firms, and that firm diversification is associated with a lower value of cash in both financially unconstrained and constrained firms. We find that firm diversification has a negative (zero) impact on the value of cash among firms with a lower (higher) level of corporate governance. These findings are consistent with the interpretation that firm diversification reduces the value of corporate cash holdings through agency problems.     

Equity compensation and the sensitivity of research and development to financial market frictions

When financial market frictions exist, executives may have to decide which investment activities to reduce when internal funds decrease. Expenditures on research and development (R&D) may be particularly vulnerable because of the long-term nature of innovative activity. We find that equity compensation is associated with lower levels of firm R&D expenditures. Rewarding executives to incur more risk has little effect on R&D expenditures, but rewarding executives for higher returns reduces R&D expenditures and makes R&D expenditures more sensitive to financial market frictions. In contrast, cash compensation reduces the sensitivity of R&D expenditures to financial market frictions.     

The size,concentration and evolution of corporate R&D spending in U.S. firms from 1976 to 2010: Evidence and implications

The use of research and development (R&D) spending as an empirical proxy for managerial discretion, information asymmetry and growth opportunities, is pervasive in empirical corporate finance research. Underlying this is the implicit assumption that firms choose levels of R&D to maximize value, given firm and industry characteristics. An alternative framework views the level of R&D spending as subject to idiosyncratic behavior as managers myopically manipulate R&D expenditures to meet short-term earnings goals. Using aggregate firm and industry level data, we find evidence consistent with the view that R&D is determined by firm and industry characteristics. Time invariant firm and industry fixed effects explain most of the cross-sectional variation in observed R&D spending, while time-varying factors like size, profitability, or market-to-book explain little of the cross-sectional variation. We find that R&D spending continues to grow faster than advertising and capital expenditures. We also find no evidence of managerial myopia as corporate aggregate R&D expenditures are growing faster than aggregate profitability and the number of firms that undertake R&D has increased over the period from 1976 to 2010.     

Investment policy in family controlled firms

We explore the relation between family ownership and corporate investment policy. Our analysis centers on two incentives, risk aversion and extended investment horizons, which potentially influence the level and type of investments that family firms undertake. We find that family firms devote less capital to long-term investments than firms with diffuse ownership structures. When dividing long-term investment into its two components of R&D and capital expenditures, we note that family firms, relative to nonfamily firms, prefer investing in physical assets relative to riskier R&D projects. Additional tests indicate that family firms receive fewer patent citations per dollar of R&D investment relative to nonfamily firms. Overall, all empirical results indicate that family preferences for lower firm risk, across all family sub-types, affects corporate R&D spending and capital expenditures.     

Shareholder governance, bondholder governance, and managerial risk-taking

We examine the relation between the overall corporate governance structure and managerial risk-taking behavior. We find that the overall governance structure has a significant impact on how managers make decisions on investment policy: strong bondholder governance motivates more low-risk investments such as capital expenditure and lower high-risk investments such as R&D expenditures, whereas weak shareholder governance (entrenched managers) leads to more R&D expenditures. Moreover, we find that the effects of governance on investment policy differ significantly between speculative and investment-grade firms. For speculative firms, strong bondholder or shareholder governance leads to more capital expenditures and low R&D investments. For investment-grade firms, strong bondholder or shareholder governance leads to low capital expenditures and an insignificant impact on R&D investments. Furthermore, financing and investment covenants exhibit strong binding power to deter risky investments. Finally, a more dependent (or a less independent) board is associated with low capital expenditures and high R&D investments.     

Corporate governance,shareholder rights and firm diversification: An empirical analysis

Grounded in agency theory, this study investigates how the strength of shareholder rights influences the extent of firm diversification and the excess value attributable to diversification. The empirical evidence reveals that the strength of shareholder rights is inversely related to the probability to diversify. Furthermore, firms where shareholder rights are more suppressed by restrictive corporate governance suffer a deeper diversification discount. Specifically, we document a 1.1–1.4% decline in firm value for each additional governance provision imposed on shareholders. An explicit distinction is made between global and industrial diversification. Our results support agency theory as an explanation for the value reduction in diversified firms. The evidence in favor of agency theory appears to be more pronounced for industrial diversification than for global diversification.     

Is the diversification discount caused by the book value bias of debt?

We analyze whether the diversification discount is driven by the book value bias of corporate debt. Book values of debt may be a more downward biased proxy of the market value of debt for diversified firms, relative to undiversified firms, as diversification leads to lower firm risk. Thus, measures of firm value based on book values of debt undervalue diversified firms relative to focused firms. Our paper complements recent literature which uses market values to test the risk reduction hypothesis for a subsample of firms for which debt is traded. Alternatively, we employ market value of debt estimates for the whole firm universe. Consistent with the above hypothesis, we show that the use of book values of debt underestimates the value of diversified firms. There is no discount for mainly equity financed firms and lower distress risk and equity volatility for diversified firms. More concentrated ownership increases firm valuation.     

Using real options theory to explain patterns in the valuation of research and development expenditures

Real options theory posits that the value of the firm is a combination of the value generated by the assets in place and the value of the option to invest in the future. It is based on the idea that many decisions are difficult to reverse, and valuing the outcome of these decisions is more complicated than estimating the present value of future cash flows. R&D activities often generate real options due to the nature of these activities, and examining the valuation of R&D expenditures through the lens of real options theory can help explain differing results documented in both the R&D and value relevance of earnings and book value literatures. Numerous studies have documented that the stock market positively values R&D expenditures; however, recent work has raised questions about whether this positive relation occurs across firms reporting both profits and losses. Consistent with real options theory, I find that the negative coefficient on the R&D expenditures of profitable firms documented by prior studies only exists for low growth firms. In addition, for all R&D firms experiencing high sales growth, the market places a lower value on assets in place and a higher value on R&D expenditures.     

Diversification and heterogeneity of investor beliefs

In the paper, we find that diversification reduces the heterogeneity of investor beliefs on firm value. We obtain this finding by comparing not only between diversified and focused firms but also between diversifying and non-diversifying mergers. We also find that the reduced heterogeneity of investor beliefs on a diversified firm relative to its focused peers is negatively associated with its contemporaneous excess value and positively associated with its future excess value. Overall, our results contribute to the understanding about how corporate organization structure affects the heterogeneity of investor beliefs and further firm value.     

CEO risk incentives and firm performance following R&D increases

In this study we analyze how CEO risk incentives affect the efficiency of research and development (R&D) investments. We examine a sample of 843 cases in which firms increase their R&D investments by an economically significant amount over the period of 1995–2006. We find that firms with higher sensitivity of CEO compensation portfolio value to stock volatility (vega) are more likely to have large increases in R&D investments. More importantly, we find that high-vega firms experience lower abnormal stock returns and lower operating performance compared to their low-vega counterparts following the R&D increases. Our main results hold in a variety of robustness tests. The results are consistent with the conjecture that high-vega compensation portfolios may induce managers to overinvest in inefficient R&D projects and therefore hurt firm performance.     

Do industrial and geographic diversifications have different effects on earnings management? Evidence from UK mergers and acquisitions

This paper examines whether corporate diversification has an impact on accruals earnings management by UK targets in mergers and acquisitions. Following prior research (Jiraporn, Kim, & Mathur, 2008; El Mehdi & Seboui, 2011), we explicitly distinguish between industrial and geographic diversification. These two dimensions of diversification differ in terms of their degree of information asymmetry, while in industrially diversified firms the accruals at the business segment level tend to offset each other, geographically diversified firms seem to be subject to higher information asymmetry. Using a sample of 229 UK publicly listed targets and employing cross-sectional accrual models and a panel regression framework, we find that industrial diversification mitigates earnings management by UK targets prior to mergers and acquisitions. The results of our study also show that a combination of industrial and geographic diversification is associated with a lesser degree of earnings management, which is consistent with those reported by Jiraporn, Kim, and Mathur (2008) and El Mehdi and Seboui (2011) for US firms. However, our evidence suggests that geographic diversification is associated with a higher degree of earnings management, however the results are not statistically significant.     

MANAGERIAL INCENTIVES AND CORPORATE DIVERSIFICATION STRATEGIES

Because the break-up of conglomerates typically produces substantial increases in shareholder wealth, many commentators have argued that the conglomerate form of organization is inefficient. This article reports the findings of a number of recent academic studies, including the authors' own, that examine the causes and consequences of corporate diversification. Although theoretical arguments suggest that corporate diversification can have benefits as well as costs, several studies have documented that diversified firms trade at a significant discount from their single-segment peers. Estimates of this discount range from 10–15% of firm value, and are larger for “unrelated” diversification than for “related” diversification. If corporate diversification has generally been a value-reducing managerial strategy, why do firms remain diversified? One possibility, which the authors label the “agency cost” hypothesis, is that top executives without substantial equity stakes may have incentives to maintain a diversification strategy even if doing so reduces shareholder wealth. But, as top managers' ownership stakes increase, they bear a greater fraction of the costs associated with value-reducing policies and are therefore less likely to take actions that reduce shareholder wealth. Also, to the extent that outside blockholders monitor managerial behavior, the agency cost hypothesis predicts that diversification will be less prevalent in firms with large outside blockholders. Consistent with this argument, the authors find that companies in which managers own a significant fraction of the firm's shares, and in which blockholders own a large fraction of shares, are significantly less likely to be diversified. If agency problems lead managers to maintain value-reducing diversification strategies, what is it that leads some of these same firms to refocus? The agency cost hypothesis predicts that managers will reduce diversification only if pressured to do so by internal or external mechanisms that reduce agency problems. Consistent with this argument, the authors find that decreases in diversification appear to be precipitated by market disciplinary forces such as block purchases, acquisition attempts, and management turnover.     

Seeking safety: The relation between CEO inside debt holdings and the riskiness of firm investment and financial policies

CEO inside debt holdings (pension benefits and deferred compensation) are generally unsecured and unfunded liabilities of the firm. Because these characteristics of inside debt expose the CEO to default risk similar to that faced by outside creditors, theory predicts that CEOs with large inside debt holdings will display lower levels of risk-seeking behavior (Jensen and Meckling, 1976). Consistent with the theoretical predictions, we find a negative association between CEO inside debt holdings and the volatility of future firm stock returns, R&D expenditures, and financial leverage, and a positive association between CEO inside debt holdings and the extent of diversification and asset liquidity. Collectively, our results provide empirical evidence suggesting that CEOs with large inside debt holdings prefer investment and financial policies that are less risky.     

Does geographic dispersion affect firm valuation?

We find that the geographic dispersion of a corporation affects its firm valuation. Firms with subsidiaries located in different regions of the United States experience a valuation discount of 6.2% after controlling for the impact of both global and industrial diversifications. The valuation discount increases as firms expand their operations to different regions nationwide. Results show that firms with more anti-takeover provisions are more likely to be geographically diverse, and that these firms experience greater value discounts compared with their counterparts with fewer such provisions. Our overall evidence suggests that the geographic location of corporate activities is an essential component of corporate policies and has important market valuation implications.     

Government R&D spending,fiscal instruments and corporate technological innovation

Using panel data from 242 cities in China, we examine the impact of government research and development (R&D) spending on corporate technological innovation. We find that listed firms located in cities with higher government R&D expenditures are more innovative than firms in other cities. Further, the positive effect of government R&D spending depends on fiscal instruments and factor allocation. Through subsidies and tax incentives, government R&D spending enhances firm innovation by alleviating financing constraints, improving employee creativity and ensuring efficient operations. We demonstrate that subsidies are more effective than taxes in spurring corporate technological innovation. We also show that the impact of government R&D spending is stronger for state-owned and high-tech enterprises than for other enterprises. Overall, our findings suggest that government R&D spending can substantially improve corporate technological innovation through fiscal instruments.     

Corporate Diversification: What Gets Discounted?

Prior literature finds that diversified firms sell at a discount relative to the sum of the imputed values of their business segments. We explore this documented discount and argue that it stems from risk–reducing effects of corporate diversification. Consistent with this risk–reduction hypothesis, we find that (a) shareholder losses in diversification are a function of firm leverage, (b) all equity firms do not exhibit a diversification discount, and (c) using book values of debt to compute excess value creates a downward bias for diversified firms. Overall, the results indicate that diversification is insignificantly related to excess firm value.     

Cross-country evidence on the value of corporate industrial and international diversification

We provide evidence on the value of industrial and international diversification for more than 3000 firms from Germany, the U.K., and the U.S. Consistent with prior studies, we find that industrial diversification reduces firm value in the U.K. and the U.S. Furthermore, similar to the recent findings of Denis et al. [J. Finance 57 (2002)], we find that U.S. multinationals trade at a discount relative to firms operating only in the domestic market. This result is robust to different benchmarks used to measure the value of diversification. By contrast, we find that international diversification has no effect on the value of firms headquartered in either Germany or the U.K.     

Tournament incentives, firm risk, and corporate policies

This paper tests the proposition that higher tournament incentives will result in greater risk-taking by senior managers in order to increase their chance of promotion to the rank of CEO. Measuring tournament incentives as the pay gap between the CEO and the next layer of senior managers, we find a significantly positive relation between firm risk and tournament incentives. Further, we find that greater tournament incentives lead to higher R&D intensity, firm focus, and leverage, but lower capital expenditures intensity. Our results support the hypothesis that option-like features of intra-organizational CEO promotion tournaments provide incentives to senior executives to increase firm risk by following riskier policies. Finally, the compensation levels and structures of executives of financial institutions have received a great deal of scrutiny after the financial crisis. In a separate examination of financial firms, we again find a significantly positive relation between firm risk and tournament incentives.     

Entrenched controlling shareholders and the performance consequences of corporate diversification in Taiwan

The main purpose of this paper is to examine the value/performance effects of corporate diversification in an emerging market. Prior evidence on this issue is still mixed. The present study adds the role of entrenched controlling shareholders into this issue. We argue that when controlling shareholders have larger excess board seats control rights, they have higher ability and incentive to expropriate minority shareholders through corporate diversification. Using a sample of firms listed on the Taiwan Stock Exchange in 2003, we find that controlling shareholders’ excess board seats control is negatively associated with the market valuation of corporate diversification. Consistently, we also document that highly diversified firms run by more entrenched controlling shareholders have lower future financial performance than otherwise similar firms. Overall, our findings imply that corporate diversification is not necessarily harmful or beneficial for firms. We conclude that the agency problem arising from the excess board seats control rights owned by controlling shareholders is an influential factor leading to negative performance consequences with regard to firm diversification.     

Coinsurance effect and bank lines of credit

The coinsurance effect hypothesis predicts that firm diversification reduces financial constraints through imperfectly correlated cash flows among segments. We empirically test the hypothesis by studying the relation between coinsurance effect and bank lines of credit. We find that coinsurance effect is associated with a higher availability of bank lines of credit, and that diversified firms hold a higher level of bank lines of credit if they have higher investment opportunities and if they are bank-dependent. We find that diversified firms hold a higher fraction of corporate liquidity in the form of bank lines of credit due to the coinsurance effect. The findings are consistent with the coinsurance effect hypothesis and contribute to the debate on the value consequence of firm diversification by disclosing a specific channel through which firm diversification affects financial constraints.