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Diversification in Firm Valuation: A Multivariate Copula Approach

Stefan Erdorf (), Thomas Hartmann-Wendels and Nicolas Heinrichs ()
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Stefan Erdorf: University of Cologne
Thomas Hartmann-Wendels: University of Cologne
Nicolas Heinrichs: University of Cologne

No 02-01, Cologne Graduate School Working Paper Series from Cologne Graduate School in Management, Economics and Social Sciences

Abstract: We introduce a new discounted cash flow model which adopts the diversification effect of multi-business firms. We face two challenges: One is examining how different diversification extents can affect the firm value due to risk reduction, and the other is modeling segment-specific cash flows and discount rates to reflect the differences in risk and growth characteristics across the different businesses that a firm operates in. Since the co-movement of business segments depends on the state of the economy, we use a multivariate copula approach taking the state-varying dependence of business segments explicitly into account. A high level of a firm's diversification determined by a low dependence between the firm's business segments leads to a lower probability of firm default which results in a higher firm value through reduced bankruptcy costs. We demonstrate this effect by comparing the values of three U.S. firms when modeling independence, dependence with copulas, and perfect dependence between businesses.

Keywords: diversification; firm valuation; dependence modeling; multi-business firm; bankruptcy costs; default probability; copulas; Monte Carlo simulation; discounted cash flow model (search for similar items in EconPapers)
JEL-codes: G11 G17 G33 L25 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-bec
Date: 2011-01
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