THE CONGLOMERATE DISCOUNT: A NEW EXPLANATION BASED ON CREDIT RISK

Manuel Ammann and Michael Verhofen ()
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Michael Verhofen: Swiss Institute of Banking and Finance, University of St. Gallen, Rosenbergstrasse 52, CH-9000, St. Gallen, Switzerland

International Journal of Theoretical and Applied Finance (IJTAF), 2006, vol. 09, issue 08, pages 1201-1214

Abstract: We present a simple new explanation for the diversification discount in the valuation of firms. We demonstrate that, ceteris paribus, limited liability of equity holders is sufficient to explain a diversification discount. To derive this result, we use a credit risk model based on the value of the firm's assets. We show that a conglomerate can be regarded as an option on a portfolio of assets. By splitting up the conglomerate, the investor receives a portfolio of options on assets. The conglomerate discount arises because the value of a portfolio of options is always equal to or higher than the value of an option on a portfolio. The magnitude of the conglomerate discount depends on the number of business units and their correlation, as well as their volatility, among other factors.

Keywords: Conglomerate; diversification; discount; credit risk; limited liability (search for similar items in EconPapers)
Date: 2006

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