For Review Only€¦ · 1 Divisional Informativeness Gap and Value Creation from Asset Sales...

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Divisional Informativeness Gap and Value Creation from

Asset Sales

Journal: The Financial Review

Manuscript ID FIRE-2015-10-161.R3

Manuscript Type: Paper Submitted for Review

Keywords: Asset sales, Divisional informativeness, Corporate restructuring, Divestitures

The Financial Review

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Divisional Informativeness Gap and Value Creation from Asset Sales

Chintal A. Desai

Manu Gupta*

Department of Finance, Insurance and Real Estate School of Business

Virginia Commonwealth University 301 West Main Street, Richmond, VA 23284 USA

April 06, 2016

Abstract

Nanda and Narayanan (1999) show that the information asymmetry between the managers and market participants regarding divisional cash flows helps explain the value creation upon asset sales. Based on their theoretical framework, the divisional informativeness gap hypothesis predicts that the announcement-period return increases with the difference in cash flow informativeness of retained and divested divisions prior to the divestiture. Our results, using industry-average earnings response coefficient as a proxy for cashflow informativeness of a division, support this prediction. The effect is stronger when a conglomerate retains the division with relatively greater growth opportunities.

JEL Codes: G34; G14 Keywords: Asset sales; Divestitures; Cash flow informativeness; Corporate restructuring

* Corresponding Author: Phone: +1 804 828 7175; Fax: +1 804 828 3972; Email: [email protected]. The authors thank an anonymous reviewer for valuable comments, which significantly improved the paper. The authors also thank the Editor, Richard Warr, for his comments. Nick DeRobertis provided excellent research assistance. Desai acknowledges summer research support from the VCU School of Business. The authors are solely responsible of errors and omissions.

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Divisional Informativeness Gap and Value Creation from Asset Sales

Abstract

Nanda and Narayanan (1999) show that the information asymmetry between the managers and market participants regarding divisional cash flows helps explain the value creation upon asset sales. Based on their theoretical framework, the divisional informativeness gap hypothesis predicts that the announcement-period return increases with the difference in cash flow informativeness of retained and divested divisions prior to the divestiture. Our results, using industry-average earnings response coefficient as a proxy for cashflow informativeness of a division, support this prediction. The effect is stronger when a conglomerate retains the division with relatively greater growth opportunities.

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1. Introduction

In an asset sale, the conglomerate divests a division, subsidiary, or product line. Nanda

and Narayanan (1999), hereafter NN, show that the information asymmetry between the

managers and the market regarding the divisional cash flows can cause undervaluation of a two-

division firm. In their model, the difference in cash flow informativeness of divisions is the key

driver of undervaluation, and hence, the source of wealth gain upon an asset sale. We form the

divisional informativeness gap hypothesis based on the theoretical framework of NN, which

predicts that the announcement-period return increases with the difference in cash flow

informativeness of the retained and divested divisions prior to divestiture.1 The objective of this

research is to test this prediction using a sample of U.S. divestitures.

We estimate the divisional informativeness gap of a conglomerate by first identifying the

three-digit Standard Industrial Classification (SIC) code of the divested and the retained

divisions based on their business operations for the year prior to the asset sale. Then, we perform

an Ordinary Least Squares (OLS) regression of earnings-announcement abnormal-return on

earnings surprises for all firms with the same three-digit SIC code as the given division. The

residual of this regression is the noise in cash flow informativeness of a division. The divisional

informativeness gap is the absolute difference between noise of cash flow informativeness of the

retained and the divested divisions.

Our results, based on a sample of 242 asset sales for the period 1990 to 2010, support the

divisional informativeness gap hypothesis. The asset sale announcement-period abnormal returns

increase with the difference in cash flow informativeness of divisions prior to the asset sale. This

1 In the next section, we review the related literature on asset sales and conceptually explain how the NN framework helps form the divisional informativeness gap hypothesis.


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effect is stronger for a conglomerate that retains the division with relatively greater growth

opportunities.

The NN model is built upon two key assumptions. First, firms sell assets to finance an

investment opportunity of the retained division. There is empirical support to this assumption.

Hovakimian and Titman (2006) empirically show that the cash from a voluntary asset sale is an

important determinant of the firm’s future investment expenditure. Borisova and Brown (2013)

find evidence that the cash from asset sale is useful for financing future Research and

Development (R&D) expenditure. Second, the market participants are unable to observe a

division’s cash flow for a given period. In reality, the firms must report performance information

of segments that represent 10% or more of consolidated sales. However, we can still not

eliminate the possibility of cross-segment shifting of earnings and expenses. Managers are likely

to manipulate divisional cash flows to avoid reporting losses of a particular division as losses

attracts more external monitoring (Hann and Lu, 2009). Chen and Zhang (2007) show that the

undervaluation of a conglomerate is a result of industry wide cross-segment shifting of earnings.

They show that a superior quality firm divests a business unit to separate itself from industry

peers, and thus overcomes undervaluation.

Our research makes two contributions to the corporate finance literature. First, it

identifies additional source of shareholders’ wealth gains upon asset sales. Second, it uses a

measure based on the industry-level earnings response coefficient for the divisional

informativeness gap of a conglomerate.

The roadmap of the paper is as follows. The next section of this paper motivates the

hypothesis development by reviewing the related literature on asset sales. The third and fourth

sections describe the sample selection process and variables including the computation of


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divisional informativeness gap, respectively. The penultimate section reports the results of

multivariate analysis. The final section concludes the paper.

2. Related literature and hypothesis development

In an asset sale transaction, a conglomerate sells an existing division, segment,

subsidiary, or a product line to a third party on a private negotiation basis. In return, the selling

firm often receives cash, and in some cases receives shares or combination of cash and shares

from the buying firm. The shareholders’ wealth, on average, increases when a conglomerate

announces an asset sale transaction.2

One strand of the corporate finance literature, especially that pertaining to corporate

restructuring, considers an asset sale as a mechanism to modify the firm’s asset portfolio and

scope.3 Corporate restructuring is also associated with efficient allocation of resources, increased

focus on the core business, and reduction in debt to attain optimal capital structure after the

divestiture. These factors are associated with the observed shareholders’ wealth gains upon an

asset sale (Bates, 2005; Clayton and Reisel, 2013; Dittmar and Shivdasani, 2003; Hite, Owers,

and Rogers, 1987; John and Ofek, 1995; Lang, Poulsen, and Stulz, 1995).

The other strand of the corporate finance literature considers an asset sale as a financing

source. A conglomerate seeking to finance investment opportunity of its growing business

division may consider selling another division when access to external capital is limited (Lang,

Poulsen, and Stulz, 1995). In two recent theoretical papers, the authors analyze a firm’s choice

between asset sales and seasoned equity offering. Edmans and Mann (2016) construct a model

2 See Rosenfeld (1984), Jain (1985), Mulherin and Boone (2000), Dittmar and Shivdasani (2003), among others. Eckbo and Thorburn (2013) survey empirical research on asset sales. 3 The other commonly used forms of restructuring are equity carve-outs and spinoffs. In an equity carve-out transaction, a conglomerate consummates an initial public offering of some portion of the subsidiary. In the case of a spinoff, a conglomerate distributes subsidiary shares to its existing shareholders.


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where a firm’s type, comprising two-dimensions – quality and synergy, is unknown to the market

participants. They identify three effects (synergy, camouflage, and correlation effects) that drive

a firm’s choice of asset sales versus equity offering. Arnold, Hackbarth, and Puhan (2015) use a

structural model with time-varying macroeconomic conditions and the consumption-based asset-

pricing framework to investigate when a firm undertakes an asset sale across business cycles.

They show that the financing through asset sales reduces the wealth transfer from equity to bond

holders. To the best of our knowledge, the genesis of the theory of financing through asset sales

goes back to NN. Their work provides a framework upon which we build our research question.

In the NN framework, for a given period, the insiders (managers) of a two-division firm

observe each division’s cash flow, whereas the market participants observe only the aggregate

cash flow of the conglomerate. Further, each division can be of strong or weak type, and only

one division has a growth opportunity. The weak division will never generate high cash flow

whereas, depending on the state of the nature, a strong division can generate high or low cash

flow. In their model, NN assume that the division with a growth opportunity generates a high

cash flow; therefore, it is a strong division. The other division, which is weak, generates low cash

flow. The market observes only the aggregate cash flow of the conglomerate and values the

conglomerate as the average of the following two scenarios. Scenario A: the division with

growth opportunity generated high cash flow and the division without growth opportunity

generated low cash flow. Scenario B: the division with growth opportunity generated low cash

flow and the division without growth opportunity generated high cash flow. In their proof of

proposition (1), NN show that the firm value under Scenario A will be higher than that under

Scenario B if and only if the cash flow informativeness of division with growth opportunity is

higher than that of division without the growth opportunity. The informational asymmetry


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regarding the divisional cash flow thus causes undervaluation of the conglomerate. The

management will likely divest the division lacking growth opportunity to finance an investment

opportunity of the growing division.

On the other hand, if the strong division has lower cash flow informativeness, then the

management will assign lower valuation to the high cash flow generated by the strong division

compared to low cash flow generated by the other division. Since the market assigns the average

value, in this case, the conglomerate will be overvalued. The managers will likely sell additional

equity to finance the growth opportunity.

The marginal extension of the NN framework is to change the assumption regarding

which division generates high or low cash flow. Suppose that, the division with growth

opportunity generates low cash flow and the division without growth opportunity generates high

cash flow. Therefore, the division without growth opportunity is of strong type, and the one with

growth opportunity is either weak or strong. The market still assigns the average value to the

conglomerate as it observes only the aggregate cash flow, and the misvaluation is possible. If the

cash flow informativeness of the division without growth opportunity is more than that of the

division with growth opportunity, then the conglomerate is undervalued by the market.

Management divests the division that lacks the growth opportunity but has generated high and

more informative cash flow in order to finance an investment opportunity for its growing but

currently low cash flow division.

To summarize, the firm will retain the division with growth opportunity. It will divest the

other division for the case where high (low) informativeness and high (low) cash flows are

together. The undervaluation of a conglomerate is a function of the difference in the cash flow

informativeness of its divisions prior to the divestiture; the higher the difference, the larger the


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undervaluation. Therefore, the divisional informativeness gap hypothesis predicts that the

announcement-period return increases with the difference in the cash flow informativeness of

retained and divested divisions prior to the asset sale.

3. Sample selection

Our initial sample of divestitures is from the Mergers and Acquisitions database of

Securities Data Corporation (SDC) for the period 1990 to 2010. We include only those

completed divestitures that had a US-based publicly traded nonfinancial (exclude SIC codes: 60

– 69) parent. We require the size of the divestiture to be at least $75 million. We exclude a

divestiture if the parent and the acquirer were identified as the same firm, if the parents were a

leveraged buyout firm, if SDC classified it as spinoffs or equity carve-outs, if the selling firm had

only a minority interest in the asset sold, or if the parents were operating under bankruptcy

protection. These steps provided an initial sample of 2,906 divestitures. Next, we merge this

sample of divestitures with Compustat and CRSP databases and eliminate divestitures that were

less than 5% of the predivestiture parent firm’s market value, which resulted in a sample of 727

divestitures.

Our variable of interest divisional informativeness gap (DIG) is based on the market

reaction to the quarterly earnings announcements of firms in the same three-digit industry as

those of divested and retained divisions. We require at least five quarterly announcements for

each industry-year group. These additional data requirements reduce the sample to 630

divestitures. In addition, for computing this measure, the retained and divested divisions need to

have different three-digit SIC code. This requirement reduces our final sample to 242 asset sales.


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Table 1 reports yearly and industry-based distribution of asset sale announcements. As

evident from Panel A, the sample firms are distributed across time, including during the period

of financial crisis (2008-2009). We observe a large number of asset-sale transactions between

years 1995 and 1999 as many conglomerates restructured their operations by undertaking asset-

sales, spinoffs, and equity carve-outs during this period. Panel B of Table 1 reports the industry-

based distribution of asset sales announcements. The industry classification is based on two-digit

SIC code. More than half of the total sample has retained division from the manufacturing sector,

followed by services and retail trade business. In the case of 16 divestitures, the divested division

belongs to the financial sector.

[Table 1 here]

4. Variables

4.1 Dependent variable

The dependent variable CAR[-1,0] measures the cumulative abnormal return during the

two-day announcement period window [-1,0].4 The divestiture announcement date refers to date

0, and it is obtained from the SDC and is verified using news articles from LexisNexis®. To

compute the announcement-period abnormal return, we apply standard event-study methodology

with returns on CRSP equal-weighted index as market returns and the estimation period starting

at 240 trading days and ending at 40 trading days prior to the divestiture announcement date. We

ensure that daily stock returns data are available for at least 30 trading days in the estimation

period.

4 We also measure cumulative abnormal return during three-day announcement period window [-1,1] and obtain similar results.


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4.2 Independent variables

4.2.1 Variable of interest - Divisional Informativeness Gap (DIG)

Prior studies show that the market reaction to earnings announcement is associated with a

firm’s information quality. Lee, Mucklow, and Ready (1993) report wider bid-ask spreads

immediately following earnings announcement, which suggests that earnings announcement

affects information risk of a firm and therefore its stock prices. Krinsky and Lee (1996) find

increase in the asymmetric component of bid-ask spread around earnings announcement, which

suggests increased uncertainty in the information environment of the firm around its earnings

announcement. Hirshleifer, Lim, and Teoh (2009) report a muted market reaction to a firm’s

earnings announcement when other firms make important announcements on the same day. They

use the market’s reaction to earnings announcement as an indicator of how well investors process

a firm’s information quality.

Motivated by the literature above cited, we construct our main variable of interest as the

difference in noise of cash flow informativeness of the divested and retained divisions, and we

term it as the “divisional informativeness gap” (DIG).5 The first step in measuring the DIG is to

appropriately identify the SIC codes for the divested and retained divisions prior to the

divestiture. We ascertain the business lines of the conglomerate by going over news reports and

SEC filings, especially 10-Ks. If the conglomerate has more than two business segments after the

divestiture, then we identify the retained division as the one with the largest revenue generating

business segment in the year prior to the asset sale. The SIC codes are based on the Department

of Labor’s website www.OSHA.org, SEC’s Edgar database, and other websites such as

www.siccodes.com.

5 We introduce “noise in cash-flow informativeness” as reverse of cash-flow informativeness.


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The second step is to measure a division’s noisiness in cash flow informativeness. It is

the root mean squared error (RMSE) for the regression of cumulative abnormal returns to

earnings announcements on earnings surprises of all firms, sharing three-digit SIC code with the

given division. We require at least five quarterly announcement for each three-digit SIC industry

to compute RMSE for that industry.6 Specifically, we perform the following regression for a

given division operating in industry � as per its three-digit SIC code:

��,�, =��, + ��, ��,�, + ��,�, (1)

where ��,�, is the cumulative abnormal return during the earnings announcement period of

the firm � operating in that industry � for the earnings announcement of quarter �. The earnings

announcement quarter � precedes the actual quarter in which the asset sale transaction has taken

place. The earnings announcement period consists of two trading days, the day before and the

day of the earnings announcement, that is [-1,0] with day 0 being the earnings announcement

day. We use equal-weighted market index as benchmark and estimate market model parameters

using data from -240 days to -40 days relative to the earnings announcement date as the

estimation period. We ensure that the stock returns data are available for a minimum of 30

trading days in the estimation period. The variable ��,�, is earnings surprise (unexpected

earnings) for firm � operating in that industry � for the quarter �. It is the ratio of the difference of

firm’s actual earnings per share and median analyst forecast of earnings per share to the firm’s

stock price at least 10 days prior to the earnings announcement. It is given by the following:

��,�, =��,�, −�� ,�,!��,�, (2)

6 We compute industry-average information quality of the divested and the retained division, and then take a difference. We use industry averages instead of measuring information quality of the predivestiture parent for two reasons. First, since the divested and the retained divisions are not publicly traded before asset sale, data on their information quality are not available. Second, by focusing on industry averages, we are able to circumvent endogeneity problem that affects the relation between market reaction to asset sale announcement and information quality of the firm.


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If a firm operates in an industry with less information asymmetry, it is likely that its

earnings announcement abnormal returns will be strongly related to its earnings surprise. Such

firms will have a lower value of � of equation (1), and hence, lower root mean squared error. We

compute the root mean square error term for both divested and retained divisions of a given asset

sale.

Finally, in the third step, we compute divisional informativeness gap (DIG) for a given

divestiture by taking the natural logarithm of the absolute difference of root mean squared error

of the divested and retained divisions. It is given by the following:

DIG = %�|��'�(�)*+*, − ��'�-*.�/*,| (3)

We proxy the noise in cash flow informativeness by RMSE of the regression of earning

announcement abnormal returns on earnings surprises (equation (1)). The underlying reason for

selecting this variable as a proxy of the noise in the cash flow informativeness is as follows:

higher RMSE of a regression indicates a lower explanation power of earning surprise in

explaining the corresponding earning announcement abnormal return, suggesting lower

information quality of the announced earnings. In addition, we have followed previous studies,

which have used the earning response coefficient as a proxy of the cash flow informativeness of

the firm (Dellavigna and Pollet, 2009; Hackenbrack and Hogan, 2002; Krishnaswami and

Subramaniam, 1999; Lennox and Park, 2006; Thomas, 2002). 7

4.2.2 Control variables

Following the literature, we control for other sources of wealth gains upon asset sales.

Warusawitharana (2008) shows that the market reaction to asset sales is positively associated

7 Nanda and Narayanan (1999) also suggest using residuals of the earnings response regression as a measure of noise in cash-flow informativeness (page 191 of their paper).


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with its proceeds. For that, we use relative size of asset sale measured as the ratio of transaction

value of the asset sale to the book value of conglomerate (RelSize). Following Clayton and

Reisel (2013), we control for firm-specific factors such as size, profitability, leverage, and

market-to-book ratio. The size of a conglomerate is the value of total assets (TA). The

profitability is the ratio of operating income to total assets (ROA), and the liquidity is the ratio of

cash and marketable securities to total assets (Liquidity). The ratios total debt to total assets

(Leverage) and market price to book price per share (M/B) are proxy for firm riskiness and

value, respectively.

Our hypothesis involves the external market assigning inappropriate valuation to a

conglomerate due to its opaqueness. Moreover, the conglomerate structure can, in some cases,

create the opaqueness and destroy value in of itself. For example, Ahn and Denis (2004) and

Gertner, Powers, and Scharfstein (2002) show that investment efficiency increases following

spinoffs, suggesting that some conglomerates inefficiently cross-subsidize in the budgeting

process. In addition, Ahn, Denis, and Denis (2006) show that conglomerates can increase value

following spinoffs by tailoring leverage policies. We therefore control for these possible motives

for a divestiture.

We use two measures to capture the investment efficiency of a conglomerate prior to

asset sale (Rajan, Servaes, and Zingales, 2000). These are relative investment efficiency (RINV)

and relative value added (RVA). RINV of �-segment conglomerate is defined as:

�012 = 34� 50�'� − 60'7�88 −34� 90�'� − 60'7�

88:/�;< =>

�;<

− 3 4� 50�'� − 60'7�88 −34� 90�'� − 60'7�

88:/�;< =/

�;/?>@<

(4)


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,where 4� is the ratio of sales of segment � to total sales of the conglomerate, 0� and '� are the

capex and sales of segment �, and AB8C�88is the capex to sales ratio of a median single-segment

firm operating in the same three-digit SIC industry as the segment �. For segments � = 1,2,⋯ , G, the industry-median Tobin’s H is greater than the conglomerate’s sales-weighted average HI,

whereas for the remaining segments � = � − G + 1,⋯ , �, the industry-median Tobin’s H is less

than the conglomerate’s sales-weighted average HI. A positive (negative) value of RINV suggests

that the conglomerate is investing relatively more (less) in high-H segments.

We compute the relative value added, RVA, of the conglomerate prior to an asset sale,

using the following equation:

�2� = 34�JH� − HIK50�'� − 60'7�88 −34� 90�'� − 60'7�

88:/�;< =/

�;< (5)

Following Ahn, Denis, and Denis (2006), we measure a firm’s excess leverage

(ExcessLev) as the difference of its ratio of total debt to book value of total assets and firm’s

imputed leverage, which in term is measured as the sales-weighted average of imputed leverage

of the firm’s segments. Imputed leverage of a segment is equal to the leverage of the median

single-segment firm that operates in the same three-digit SIC industry as that segment.

The wealth gain following corporate divestiture can be attributed to the better

management of the retained assets in the post-divestiture period (John and Ofek, 1995). In our

sample, we focus only on divestitures where sold and retained divisions are in different

industries, and thus each divestiture is focus increasing. We construct Herfindahl Index (H-

Index) of the conglomerate prior to the asset sale as a control for the differing level of the focus

and its impact on the wealth gains. It is the sum of the square of a segment’s sales to the


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conglomerate sales. Its values close to one and zero indicate that a conglomerate’s operations are

the most and the least focused, respectively.

We use SDC, Compustat and CRSP for computation of the above-mentioned continuous

independent variables. In addition, we measure these variables in the fiscal year prior to the

divestiture announcement. Finally, Lang, Poulsen, and Stulz (1995) show that the value gains

from asset sales are restricted to subsample when the sale proceeds are used for debt repayment

or equity payout. We construct a dummy variable (Use_Debt), which is equal to one if the news

announcement indicates that the reason for conducting an asset sale is to reduce debt.8

4.3 Summary statistics

Table 2 presents summary statistics of the sample. The mean and median two-day

announcement period return are 2.51% and 1.27%, respectively. These numbers are comparable

to those reported in the literature. The mean and median values of DIG for the sample are -4.39

and -4.24, respectively. On average, a conglomerate raises around 29% of its book value of

assets through an asset sale transaction. The mean and median values of total assets of a

conglomerate before divestiture are $4.3 billion and $1.4 billion, respectively. On average, a

typical sample firm has 8.8% of its total assets in cash and equivalents, 28% of its total assets are

financed by long-term debt, and it has operating income before depreciation to the magnitude of

10% of its total assets. For 48 sample firms, the segment data are not available. Therefore, the

sample size is 194 for RINV, RVA, ExcessLev, and H-Index. Finally, in 83 out of 242

conglomerates, the news articles reporting the asset sale announcements state that the reason of

an asset sale is to reduce the debt.

8 We also use a dummy variable that takes on a value of one if the reason for asset sale is either to reduce the debt or to distribute cash through dividend and stock purchase. We find results similar to the ones obtained using the dummy Use_Debt.


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[Table 2 here]

5. Results

To assess the effect of divisional informativeness gap on shareholders’ wealth gains upon

asset sales, we run the following cross-sectional regression:

CAR[−1,0]� = � +�< ∗ DIG� +3�> ∗ �2�,>S>;T + �� (6)

Where, CAR[−1,0]� is the two-day announcement-period return of firm � when it announces a

divestiture, DIG� is the divisional informativeness gap for firm �, and �2�,> is a set of G control

variables for firm �. We control for time fixed-effect in all the specifications to control for

economic conditions and other factors that affect temporal distribution of divestitures. Since our

measure of DIG is based on industry averages, we correct standard error for industry clusters.

Table 3 reports the results of multivariate analysis. In the first specification, we use DIG

and controlling factors where we have available data for the entire sample of 242 divestitures. In

the second and third specifications, we add measures of investment efficiency, excess leverage,

and improved focus. The difference between the second and third specification is that we use

RINV and RVA interchangeably. As reported in specification (1), the coefficient of 0.009 on

DIG is positive and statistically significant at the 5% level. It indicates that one standard

deviation increase in DIG is associated with 1.10 percentage-points (≈ 1.22 x .009) increase in

two-day announcement-period return. Considering the average value of announcement period

return of 2.51 % for the sample of asset sales, this change is economically significant. We find

similar results in specifications (2) and (3), where we control for other sources of wealth gains.


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Regarding the effects of control variables, the size of sale proceeds increases the market

reaction. This result is consistent with Clayton and Reisel (2013) and Warusawitharana (2008).

In addition, less profitable firms have higher abnormal return, which is intuitive. The lower

profitability may be the result of inefficient resource allocation and poor management, resulting

in lower valuation by the market. An asset sale signals the positive change by the management,

which can result in the higher announcement-period return. The coefficient on investment

efficiency, as measured by RINV, is positive and statistically significant. Our prior is that

conglomerates with a more negative RINV (those firms investing relatively less in high growth

divisions) would benefit the most from an asset sale. Thus, we should observe negative

coefficients in our tests. One plausible explanation for this result is the structural difference

between spinoffs, which were the subject of Ahn and Denis (2004), and asset sales. Unlike a

spinoff, in the case of an asset sale, the firm receives capital, which we note will most likely be

used for investment. The market has to ascertain whether the capital will be used for a valuable

growth opportunity. A firm with a history of investing more efficiently (i.e., higher RINV)

might be received more favorably by the market to the news of an influx of unencumbered

capital.

Overall, the results of Table 3 support the divisional informativeness gap hypothesis. The

announcement period return increases with the difference in cash-flow informativeness of

retained and divested divisions.

[Table 3 here]

One of the key assumption of the NN model is that the retained division of the

conglomerate has investment opportunity and that the firm will use proceeds of the asset sale to

finance this opportunity. Implicitly, it assumes that the retained division has more growth


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opportunities than the divested division. Therefore, it is likely that the divisional informativeness

gap hypothesis is more relevant among the divestitures in which retained divisions have higher

growth opportunities. To test this possibility, we modify our regressions of equation (6) and

include an interaction term of DIG and a variable capturing the differential growth opportunities.

A positive coefficient of this interaction term affirms our conjecture.

Specifically, based on the three-digit SIC code of the division’s industry, we compute

average market-to-book ratio of all the firms operating in the same three-digit SIC code for the

year prior to the asset sale announcement. This average market-to-book ratio is the proxy for the

growth opportunities of the division. Then, we construct a dummy variable (HighG) that takes on

a value of one if the retained division’s industry market-to-book ratio is more than that of the

divested division. Out of 242 sample asset-sales, for 131 divestitures the retained division has

more growth opportunities, resulting in a value of High G equal to one.

Table 4 reports the results of analysis using the interaction term of DIG and HighG. As

reported in Table 4, the coefficient on DIG is close to zero and statistically insignificant. It

suggests that the divisional informativeness gap hypothesis is less relevant in the case of

subsample firms where divested division has more growth opportunities than retained division.

Moreover, the coefficient of DIG x HighG is positive and statistically significant in all the

specifications. For example, the coefficient of 0.017 in specification (1) indicates that the effect

of DIG on the announcement-period return is larger by 0.017 for the subsample of firms where

the retained division has more growth opportunities than the divested division. This difference is

statistically significant at the 1% level. The effects of controlling factors remain similar to the

ones reported in Table 3.9 The net effect of DIG on the announcement-period return for the

9 In an unreported analysis, we redefine the firms with growth opportunities for their retained division as the ones that indicate that the sale proceeds are for the general corporate purpose and not for the debt reduction or payout


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sample in which retained division has more growth opportunity than the divested division is

shown by the sum of regression coefficients of DIG and DIG x HighG. As seen in the last row of

Table 4, this effect is significant at the 1% level.

Overall, the results of Table 4 illustrate that the prediction of the divisional

informativeness gap hypothesis is stronger when a conglomerate retains its growing division and

sells off its division lacking the growth opportunities.

[Table 4 here]

In our analysis so far, we use the absolute value of the difference in noise in cash-flow

informativeness of the retained and divested divisions and thus combine two scenarios: (a) the

noise in cash-flow informativeness of the divested division is higher than that of the retained

division; and (b) the noise in cash-flow informativeness of the retained division is higher than

that of the divested division. It is possible that only one of these two scenarios drives the

marginal effect of DIG on the cumulative abnormal return, as reported in Table 3. For assessing

this possibility, we construct a dummy variable NoiseDiff_D that takes on a value of one if the

noise in cash-flow informativeness of the retained division is higher than the noise in cash-flow

informativeness of the divested division and zero otherwise, and use its interaction term with

DIG.10

As shown in Table 5, the coefficient of the interaction term NoiseDiff_D × DIG is

statistically indistinguishable from zero in all the specifications. For example, the coefficient of

this interaction term in specification (1) is -0.005. It suggests that the marginal effect of DIG on

CAR[-1,0] is 0.013 for the subsample in which the noise in cash-flow informativeness of the

divested division is higher than that of the retained division. This marginal effect is 0.008 [0.013

policy. We find qualitatively similar results. 10 In a sample of 242 asset sales, we have 109 observations where the value of NoiseDiff_D is one.


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– 0.005] for the subsample where the noise in cash-flow informativeness of the retained division

is higher than that of the divested division. Recall that, for the total sample of 242 asset-sales, the

marginal effect of DIG on two-day announcement period abnormal return was 0.009 as per the

specification (1) of Table 3. Therefore, the marginal effects of these two subsamples are not

statistically different from the one obtained by using the entire sample.

Overall, the results of Table 5 lend support to the conjecture that the DIG effect as

obtained in Table 3 is not driven by only one of the two alternative scenarios we stated above.

This result validates the use of absolute value of the difference between noise in cash-flow

informativeness of divested and retained divisions as measure of the divisional informational

gap.

[Table 5 here]

6. Conclusions

In an asset sale, a conglomerate sells its division, product line, or subsidiary to a third

party on a private negotiation basis. It is a value-enhancing transaction for the parent firm’s

shareholders. In this paper, we show that the difference in cash-flow informativeness of the

retained and divested divisions is a source of wealth gains.

Nanda and Narayanan (1999) provide the theoretical support for our empirical work.

Their model builds on the information asymmetry between managers and shareholders regarding

the divisional cash flows. For a given period, the managers (insiders) observe the actual cash

flow of each division, whereas the outsiders (market participants) observe only the aggregate

cash flow of the conglomerate. To finance an investment opportunity, management rationally

divests a division when the market undervalues the conglomerate. In their model, the necessary


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condition of undervaluation is the difference in cash-flow informativeness of retained and

divested divisions. Therefore, the divisional informativeness gap hypothesis predicts that the

announcement-period abnormal return increases with the difference in cash-flow informativeness

of the retained and divested divisions.

We use sample of 242 asset sales for the period 1990 to 2010 to test the prediction of the

divisional informativeness gap hypothesis. We use earnings response coefficient as a proxy for a

division’s cash-flow informativeness. Our results show that the effect of divisional

informativeness gap of a conglomerate prior to the asset sale helps explain its announcement-

period return. Further, we notice that the effect is stronger for the divestitures where the retained

divisions have larger growth opportunities than those of divested divisions. Overall, our results

support the divisional informativeness gap hypothesis.


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References

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Table 1

Distribution of divestitures over time and industry

Panel A of Table 1 reports the year-wise distribution of asset sales based on the transaction date. We obtain the sample of asset sales from the SDC. The two-digit SIC classification shown in Panel B is based on Department of Labor’s website www.osha.gov.

Panel A: Year-wise frequency distribution of divestitures

Year Sample firms

1990 5

1991 3

1992 3

1993 7

1994 11

1995 13

1996 22

1997 26

1998 17

1999 32

2000 18

2001 13

2002 5

2003 5

2004 12

2005 9

2006 21

2007 11

2008 3

2009 1

2010 5

Total 242

Panel B: Frequency distribution based on division’s industry Industry SIC 2-digit Sample firms

Retained Divested

Mining 10-14 11 9

Manufacturing 20-39 159 130

Transportation, Communication, Electric, Gas, and Sanitary services

40-49 12 25

Wholesale trade 50-51 11 11

Retail trade 52-59 13 8

Financials 62-69 0 16

Services 70-89 36 43

Total 242 242


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Table 2

Sample summary statistics

The dependent variable CAR[-1,0] measures the cumulative abnormal return during the two-day announcement period window [-

1,0]. The divestiture announcement date refers to date 0. We compute CAR[-1,0] using the standard event-study methodology

with returns on CRSP equal-weighted index as the benchmark market returns and the estimation period from -240 trading days to

-40 trading days relative to the divestiture announcement date. The abbreviation DIG is the divisional informativeness gap. It is

the natural logarithm of the absolute difference of the noise in cash-flow informativeness of divested and retained divisions. The

noise in the cash-flow informativeness of a division is the root mean square error of the regression of earnings announcement-

period abnormal return on earnings surprises of all the firms that share three-digit SIC code with the given division. RelSize is

the ratio of transaction value of the asset sale to the book value of conglomerate. TA is the size of a conglomerate measured by its

value of total assets. ROA measures profitability, and it is the ratio of operating income to total assets. Liquidity is the ratio of

cash and marketable securities to total assets. Leverage is the ratio of total debt to total assets. M/B is the ratio of market price to

book price per share. Herfindahl Index (H-Index) is the sum of the squares of the ratio of a segment’s sales to the conglomerate’s

total sales. Excess leverage (ExcessLev) is the difference of a conglomerate’s ratio of total debt to book value of total assets and

its imputed leverage. The imputed leverage of a firm is the sales-weighted average of the imputed leverage of its segments. The

imputed leverage of a segment is the leverage of the median single-segment firm that shares three-digit SIC code of the segment.

RINV and RVA measure the investment efficiency of the firm and are computed using equations (4) and (5), respectively. All the

continuous independent variables are computed for the previous year to the asset sale announcement. The dummy variable,

Use_Debt, equals to one if the news announcement indicates that the reason for conducting an asset sale is to reduce the debt, and

zero otherwise. N is the number of asset sales.

Variable N Mean Std. dev. Median 5th percentile

95th percentile

CAR[-1,0] 242 0.0251 0.0785 0.0127 -0.0703 0.1523

DIG 242 -4.3900 1.2200 -4.2400 -6.4100 -2.8800

RelSize 242 0.2860 0.2869 0.1857 0.0719 0.8192

TA 242 4,330 7,380 1,420 200 20,200

M/B 242 1.494 0.584 1.329 0.8597 2.5410

ROA 242 0.1003 0.0856 0.1128 -0.0386 0.2054

Liquidity 242 0.0877 0.1264 0.0368 0.0040 0.3462

Leverage 242 0.2822 0.2038 0.2462 0.0004 0.6282

H-Index 194 0.4742 0.1773 0.4499 0.2391 0.7802

ExcessLev 194 -0.0148 0.0585 0 -0.1171 0.0000

RINV 194 0.0020 0.0401 0 -0.0349 0.0653

RVA 194 0.0004 0.0278 0 -0.0248 0.0280

Use_Debt (Dummy) 242 0.3430 0.4757


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Table 3

Announcement-period return and divisional informativeness gap

The dependent variable CAR[-1,0] is the cumulative abnormal return during the two-day announcement period of asset sale. The independent variable DIG measures the relative noisiness in cash-flow informativeness of divested and retained divisions. It is the natural logarithm of the absolute difference of the noisiness in cash-flow informativeness of divested and retained divisions. The noise in the cash-flow informativeness of a division is the root mean square error of the regression of earnings announcement-period abnormal return on earnings surprises of all the firms that share three-digit SIC code with the given division. RelSize is the ratio of transaction value of the asset sale to the book value of conglomerate. TA is the size of a conglomerate measured by its value of total assets. ROA measures profitability and it is the ratio of operating income to total assets. Liquidity is the ratio of cash and marketable securities to total assets. Leverage is the ratio of total debt to total assets. M/B is the ratio of market price to book price per share. Herfindahl Index (H-Index) is the sum of the squares of the ratio of a segment’s sales to the conglomerate’s total sales. Excess leverage (ExcessLev) is the difference of a conglomerate’s ratio of total debt to book value of total assets and its imputed leverage. The imputed leverage of a firm is the sales-weighted average of the imputed leverage of its segments. The imputed leverage of a segment is the leverage of the median single-segment firm that shares three-digit SIC code of the segment. RINV and RVA measure the investment efficiency of the firm and are computed using equations (4) and (5), respectively. All the continuous independent variables are computed for the previous year to the asset sale announcement. The dummy variable, Use_Debt, equals to one if the news announcement indicates that the reason for conducting an asset sale is to reduce the debt and zero otherwise. In all specifications, we control for time-fixed effects and correct standard errors for industry clustering. N is the number of observations, and Ln is the natural logarithm. The p-values are reported in parentheses below the coefficients.

(1) (2) (3)

DIG 0.009 0.010 0.010 (0.021)** (0.025)** (0.029)**

Ln(RelSize) 0.020 0.018 0.018 (0.006)*** (0.025)** (0.024)**

Ln(TA) -0.001 -0.003 -0.003 (0.718) (0.397) (0.407)

ROA -0.140 -0.311 -0.307 (0.096)* (0.000)*** (0.000)***

Liquidity -0.042 -0.069 -0.070 (0.352) (0.308) (0.295)

Leverage 0.004 (0.838) M/B 0.003 0.015 0.014 (0.774) (0.228) (0.248)

Use_Debt -0.013 -0.015 -0.014 (0.119) (0.117) (0.157)

Excess Lev -0.121 -0.114 (0.137) (0.150)

H-Index -0.030 -0.030 (0.270) (0.268)

RINV 0.208 (0.025)** RVA 0.129 (0.512)

Constant 0.120 0.153 0.153 (0.002)*** (0.001)*** (0.001)***

Adjusted-R2 0.165 0.294 0.284 N 242 194 194

***, **, and * indicate statistical significance at the 0.01, 0.05 and 0.10 levels, respectively.


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Table 4 Announcement-period abnormal return and DIG in high-growth firms The dependent variable CAR[-1,0] is the cumulative abnormal return during the announcement period of asset sale. The DIG measures the relative noisiness in cash-flow informativeness of divested and retained divisions. It is the natural logarithm of the absolute difference of the noisiness in cash-flow informativeness of divested and retained divisions. The noise in the cash-flow informativeness of a division is the root mean square error of the regression of earnings announcement-period abnormal return on earnings surprises of all the firms that share three-digit SIC code with the given division. HighG equals to one if the growth opportunity of retained division is higher than that of divested division. The growth opportunity of a division is the average market-to-book ratio of all the firms operating in the same three-digit SIC code as that of the division. RelSize is the ratio of transaction value of the asset sale to the book value of conglomerate. TA is the size of a conglomerate measured by its value of total assets. ROA measures profitability and it is the ratio of operating income to total assets. Liquidity is the ratio of cash and marketable securities to total assets. Leverage is the ratio of total debt to total assets. M/B is the ratio of market price to book price per share. Herfindahl Index (H-Index) is the sum of the squares of the ratio of a segment’s sales to the conglomerate’s total sales. Excess leverage (ExcessLev) is the difference of a conglomerate’s ratio of total debt to book value of total assets and its imputed leverage. The imputed leverage of a firm is the sales-weighted average of the imputed leverage of its segments. The imputed leverage of a segment is the leverage of the median single-segment firm that shares three-digit SIC code of the segment. RINV and RVA measure the investment efficiency of the firm and are computed using equations (4) and (5), respectively. All the continuous independent variables are computed for the previous year to the asset sale announcement. Use_Debt equals to one if the news announcement indicates that the reason for conducting an asset sale is to reduce the debt, and zero otherwise. In all the specifications, we control for time-fixed effects and correct standard errors for industry clustering. The p-values are in parentheses below the coefficients. N is the number of observations, and Ln is the natural logarithm.

(1) (2) (3)

DIG -0.002 0.003 0.003 (0.720) (0.588) (0.668)

HighG 0.076 0.058 0.062 (0.006)*** (0.077)* (0.063)*

DIG x HighG 0.017 0.012 0.013 (0.005)*** (0.091)* (0.078)*

Ln(RelSize) 0.019 0.018 0.018 (0.009)*** (0.021)** (0.020)**

Ln(TA) -0.001 -0.002 -0.002 (0.814) (0.506) (0.518)

ROA -0.136 -0.301 -0.297 (0.100)* (0.001)*** (0.001)***

Liquidity -0.035 -0.063 -0.063 (0.454) (0.365) (0.354)

Leverage 0.002 (0.939) M/B 0.005 0.016 0.015 (0.623) (0.185) (0.196)

Use_Debt -0.013 -0.014 -0.013 (0.142) (0.150) (0.196)

Excess Lev -0.116 -0.110 (0.163) (0.174)

H-Index -0.029 -0.029 (0.287) (0.286)

RINV 0.193 (0.039)** RVA 0.121 (0.546)

Constant 0.067 0.115 0.112 (0.139) (0.032)** (0.036)**

Adjusted-R2 0.175 0.295 0.287 N 242 194 194

DIG + DIGxHighG

0.015 (0.000)***

0.015 (0.000)***

0.016 (0.000)***



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Table 5 Abnormal return and interaction of DIG with Indicator for divested division having

relatively less noise The dependent variable CAR[-1,0] is the cumulative abnormal return during the announcement period of asset sale. The DIG measures the relative noisiness in cash-flow informativeness of divested and retained divisions. It is the natural logarithm of the absolute difference of the noisiness in cash-flow informativeness of divested and retained divisions. The noise in the cash-flow informativeness of a division is the root mean square error of the regression of earnings announcement-period abnormal return on earnings surprises of all the firms that share three-digit SIC code with the given division. The indicator variable NoiseDiff_D equals to one when the retained division has higher noise in cash-flow informativeness than the divested division and zero otherwise. RelSize is the ratio of transaction value of the asset sale to the book value of conglomerate. TA is the size of a conglomerate measured by its value of total assets. ROA measures profitability and it is the ratio of operating income to total assets. Liquidity is the ratio of cash and marketable securities to total assets. Leverage is the ratio of total debt to total assets. M/B is the ratio of market price to book price per share. Herfindahl Index (H-Index) is the sum of the squares of the ratio of a segment’s sales to the conglomerate’s total sales. Excess leverage (ExcessLev) is the difference of a conglomerate’s ratio of total debt to book value of total assets and its imputed leverage. The imputed leverage of a firm is the sales-weighted average of the imputed leverage of its segments. The imputed leverage of a segment is the leverage of the median single-segment firm that shares three-digit SIC code of the segment. RINV and RVA measure the investment efficiency of the firm and are computed using equations (4) and (5), respectively. All the continuous independent variables are computed for the previous year to the asset sale announcement. Use_Debt equals to one if the news announcement indicates that the reason for conducting an asset sale is to reduce the debt, and zero otherwise. In all the specifications, we control for time-fixed effects and correct standard errors for industry clustering. The p-values are in parentheses below the coefficients. N is the number of observations, and Ln is the natural logarithm.

(1) (2) (3)

DIG 0.013 0.014 0.014 (0.038)** (0.041)** (0.043)**

NoiseDiff_D -0.002 -0.005 -0.003 (0.956) (0.899) (0.937)

NoiseDiff_D × DIG -0.005 -0.006 -0.006 (0.482) (0.511) (0.523)

Ln(RelSize) 0.020 0.018 0.019 (0.005)*** (0.016)** (0.015)**

Ln(TA) 0.000 -0.002 -0.002 (0.982) (0.619) (0.648)

ROA -0.143 -0.329 -0.327 (0.087)* (0.000)*** (0.001)***

Liquidity -0.041 -0.085 -0.086 (0.406) (0.210) (0.196)

Leverage 0.005 (0.808)

M/B 0.004 0.018 0.017 (0.714) (0.149) (0.156)

Use_Debt -0.013 -0.015 -0.013 (0.130) (0.123) (0.162)

Excess Lev -0.125 -0.120 (0.136) (0.146)

H-Index -0.034 -0.034 (0.199) (0.193)

RINV 0.171 (0.069)*

RVA 0.099 (0.609)

Constant 0.116 0.154 0.152 (0.007)*** (0.004)*** (0.004)***

Adjusted-R2 0.177 0.303 0.296 N 242 194 194



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For Review Only€¦ · 1 Divisional Informativeness Gap and Value Creation from Asset Sales...

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