Topic 8 - Diversification and Corporate Governance Flashcards
Why diversify?
Diversification reduces business risk (the standard deviation) as long as the returns from the new line of business are less than perfectly positively correlated with returns on existing assets.
How do you maximise risk reduction generally through diversifying?
Risk reduction is greater as the risks of new segments are more unrelated to existing segments.
What is a counter argument for the diversification of firms, if managers claim that a second segment of operations is good ‘backup’ in case the other segment makes losses?
Firms should sell or abandon a loss-making segment and keep the profitable one. No need for diversification.
Why do shareholders not value risk reduction measures (diversifying) taken by firms? what is the exception to this rule? what is the exception to this rule?
Shareholders can do this themselves by holding a diversified portfolio, when a firm tries to diversify this is an expensive process (i.e. premium).
Exception, closely held firms or private firms with un-diversified shareholders, however they may be sacrificing growth opportunities to do so.
Who gains from diversification?
Bondholders and lenders gain from lower risk.
- the equity call and the default put (of equity- holders) are worth less, so there is a wealth transfer from equityholders to debt holders
What effect does a merger purely for diversification have on the combined value of the two firms?
None, a diversification motive implies near-zero correlation of returns between the two independent firms hence the value stays the same, as there are no gains from synergies.
How do stock prices from a diversified firm differ in price from a focused firm?
on average they sell for 5-15% less
ie More shareholder wealth is destroyed as firms diversify
What does the Stowe and Xing article look at?
the possibility the observed diversification discount is due to the difference in growth opportunities between diversified and single- segment firms
What were the key findings of the the Stowe and Xing article? (3)
- Diversifying firms on average have fewer growth opportunities than single-segment firms.
- The growth difference occurs before firms diversify not due to diversification, diversification itself makes insignificant difference to growth opportunities
- On average value of diversified firms is still about 7% lower than the sum of the values of the matched single-segment firms
What is Corporate Governance?
The system of controls, rules and incentives instigated by shareholders and designed to minimize agency costs between managers and investors and prevent corporate fraud.
What is the role of corporate governance?
- to mitigate the conflict of interest between investors and mgmt, without excessively burdening managers with the risk of the firm
How is alignment of directors’ interest with that of shareholders usually achieved? (5)
- Large percentage of outside or non-executive directors represented on the board
- Inside or executive directors own a significant portion of company’s stock
- CEOs have limited power in the appointment of new directors
- Regular independent reviews of CEO performance
- And possibly a limit on board size
what is an Executive director?
An inside director- are also employees.
What is the role of independent directors? why do they sometimes not do a good job of this?
Outside or non- executive directors monitor inside (or executive) directors on behalf of the shareholders.
- Personal wealth through their fees is likely to be less sensitive to performance than that of insider, they may have less incentive to closely monitor the firm
What are the benefits of a small board? (5)
If board is large:
- slower decision-making,
- less-candid discussions of managerial performance, and - biases against risk- taking.
- Large boards function less effectively
- are easier for CEOs to control (out of self-interest) than are small boards