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Corporate Finance 49

The CFA Digest • Fall 1997

CORPORATE FINANCE

Agency Problems, Equity Ownership, andCorporate Diversification

David J. Denis, Diane K. Denis, and Atulya Sarin

 Journal of Finance

vol. 52, no. 1 (March 1997):135–60

Corporate diversification causes a loss of market value

for the firm. The authors find evidence that the loss ofmarket value is an agency cost. As the degree ofmanagerial ownership rises, the degree of corporatediversification falls. They also find that external corpo-rate control events often precede the divestiture ofcorporate segments.

Recent evidence suggests that the costs of corporate diversifica-tion outweigh the benefits. The authors test the hypotheses thatmanagers receive private benefits from diversifying lines of busi-ness and that the resulting loss of market value is, therefore, anagency cost. They also test the hypothesis that effective monitor-ing of corporate activity reduces the degree of diversification andthus reduces those agency costs.

Berger and Ofek ( Journal of Financial Economics, 1995), Langand Stulz ( Journal of Political Economy, 1994), and Servaes( Journal of Finance, 1996) find significant losses in market valueresulting from corporate diversification. Managers, however, mayreceive private benefits from diversification in the form of pres-tige, added compensation, or job security. If managers do receivethose benefits, then the loss of market value associated with diver-sification is an agency cost borne by the shareholders.

David J. Denis and Diane K. Denis are at Purdue University. Atulya Sarinis at Santa Clara University. The abstract was prepared by Robert A.McLean, CFA, the University of Alabama at Birmingham.

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50 Corporate Finance

©Association for Investment Management and Research

The authors use the Value Line universe of firms and restrict theirsample to those firms that had sales of at least $20 million and nosales in the financial services or regulated utilities industries in1985, as reported in COMPUSTAT’s Industry Segment file. Theresulting sample includes 933 firms. They draw data on equityownership from the firms’ last proxy statements prior to Decem-ber 1984. To measure diversification, the authors use (1) the frac-tion of firms with multiple segments, (2) the number of segmentsreported by management, (3) the number of four-digit SIC codesthat COMPUSTAT assigns the firm, (4) a revenue-based Herfind-

ahl index, and (5) an asset-based Herfindahl index. Finally, the au-thors use Berger and Ofek’s measure of the excess value

associated with diversification: the firm’s total market value (mar-ket value of equity plus book value of debt) minus the imputedvalue of the firm’s segments as stand-alone businesses.

As managers’ share of equity ownership in the firm increases, themanagers bear a progressively larger share of the agency costs of diversification. Therefore, the authors hypothesize that as manag-ers’ share of ownership increases, the degree of diversification

will fall. They test this hypothesis and find a consistent negativerelationship between managers’ equity share and the degree of di-versification.

Amihud and Lev ( Bell Journal of Economics, 1981) suggest thatas managers’ ownership share increases, they will engage in morediversification in order to reduce personal risk. The authors incor-porate that hypothesis into their model by allowing the ownership

share/diversification to be nonlinear. They find some evidence forAmihud and Lev’s hypothesis at very high levels of managerialownership. The authors note that this evidence applies to only 13of the 933 firms in the sample. Thus, the vast majority of samplefirms fall into the category in which diversification is negativelyrelated to managerial ownership.

The authors determine that significant negative excess values areassociated with diversification, but they find little support for thehypothesis that negative excess values change as the degree of managerial ownership changes. Furthermore, the authors find that

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Corporate Finance 51

The CFA Digest • Fall 1997

changes in the degree of diversification are associated with signif-icant negative excess value (resulting from diversification), cor-porate control events, and product/market failures.

Diversification causes a loss of market value for firms. The size of 

that loss of market value is not related to the degree of managerialownership. The degree of diversification, however, falls as the de-gree of managerial ownership (and, therefore, the degree to whichmanagers bear agency costs) rises. External corporate controlevents, which indicate enhanced market monitoring, often precededecreases in diversification.