The cost of capital effect of M&A transactions: Disentangling coinsurance from the diversification discount

• DOI: http://doi.org/10.1111/eufm.12177
• Published date: 01 September 2018
• Author: Mario Fischer,Patrick Bielstein,Christoph Kaserer
• Date: 01 September 2018

DOI: 10.1111/eufm.12177

ORIGINAL ARTICLE

The cost of capital effect of M&A transactions:

Disentangling coinsurance from the diversification

discount

Patrick Bielstein

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Mario Fischer

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Christoph Kaserer

TUM School of Management, Technical

University of Munich, Arcisstr. 21, 80333

Munich, Germany

Emails: christoph.kaserer@tum.de;

mario.fischer@tum.de;

patrick.bielstein@tum.de

Abstract

This study argues that in corporate diversification there is a

bright side (coinsurance effect) and a dark side (diversifi-

cation discount). While diversification might reduce

systematic risk by its impact on the cost of financial

distress, it might increase systematic risk because of

inefficient cross-subsidization at the same time. Building

on an extension of the model of Hann, Ogneva, and Ozbas

(2013), we analyze mergers and acquisitions in the US over

the period 1985 to 2014. We find the coinsurance effect to

decrease the cost of capital by 36 basis points for the

average firm. However, at the same time, we observe a 7

basis points increase in the cost of capital related to the

inefficiency of the firm's internal capital market. Both

effects are statistically significant and robust to endogeneity

concerns, different empirical specifications, and variable

measurement.

KEYWORDS

corporate diversification, cost of capital, internal capital markets, M&A

transactions

Christoph is the corresponding author. We thank Daniel Bens, Daniel Bias, Tobias Berg, Matthias Hanauer, Pekka Hietala,

Christoph Jäckel, Steven Monahan, Ignacio Requejo, Matthew Spiegel, Farzad Saidi, Jacob Thomas, and Heather Tookes

for input and stimulating discussions. We also thank an anonymous referee for insightful suggestions. Furthermore, we

appreciate helpful comments from participants at the Munich Finance Day, the brown bag seminars at TUM School of

Management and INSEAD Finance Department, the International Finance and Banking Society (IFABS) corporate finance

conference at Oxford University, the 2015 Financial Management Association (FMA) annual meeting in Orlando, and the

23rd annual conference of the Multinational Finance Society (MFS) in Stockholm. Part of this research was developed in

the context of Patrick's and Mario's Ph.D.-theses and conducted while Patrick was at INSEAD and Mario was at Harvard

University and Yale University. All errors are our own.

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© 2018 John Wiley & Sons, Ltd. wileyonlinelibrary.com/journal/eufm Eur Financ Manag. 2018;24:650–679.

JEL CLASSIFICATION

G24, G32, G34

1

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INTRODUCTION

Whether corporate diversification has a positive or negative impact on a firm's cost of capital is an

ongoing debate. We contribute to this discussion by reconciling two conflicting views: the coinsurance

effect and the diversification discount. Our starting point is the paper by Hann et al. (2013) who show

that corporate diversification reduces the deadweight cost of financial distress. As this cost is related to

the business cycle, diversification reduces systematic risk and hence, the firm's cost of capital. We refer

to this finding as the coinsurance effect.

In contrast, other studies show that diversified companies have a lower valuation than their stand-

alone peers (e.g., Berger & Ofek, 1995; Lang & Stulz, 1994). This lower valuation, which is labeled as

the diversification discount, could be caused by either lower expected cash flows or a higher cost of

capital. So far, most of the literature has focused on the first explanation, suggesting that allocational

problems on internal capital markets are responsible for negative cash flow effects (e.g., Lamont, 1997;

Lang & Stulz, 1994). As a consequence, there is only limited evidence as to whether, and if so, to what

extent, the diversification discount might be driven by a discount rate effect, i.e., by an increase in

systematic risk of diversified firms and, as a consequence, in their cost of capital (Lamont & Polk,

2001). It is the aim of this paper to present new evidence on the discount rate effect of diversification

decisions.

An established finding in the literature on the diversification discount relates to cross-subsidization

through internal capital markets. Actually, Lamont (1997) shows that conglomerates reallocate funds

within the firm. Gertner, Powers, and Scharfstein (2002) and Shin & Stulz (1998) document that

investment efficiency is inversely related to the degree of diversification. Maksimovic and Phillips

(2002) develop a theoretical model that predicts different investment behaviour of diversified and

focused firms, which, as the authors show, is in line with empirical evidence. Moreover, divisional

rent-seeking (Scharfstein & Stein, 2000), transfer of competencies (Matsusaka, 2001) or management

perquisites (Aggarwal & Samwick, 2003) are considered as well.

Based on this corporate diversification literature, this paper aims to make a threefold contribution.

First, we start from the aforementioned cross-subsidization finding in conglomerates and show, by

extending the model of Hann et al. (2013), that this cross-subsidization is suitable to increase a firm's

systematic risk and, as a consequence, its cost of capital. The intuition behind our model is that

inefficient internal capital markets lead to losses through foregone investment opportunities, which

have a more negative impact on profitability in bad states of the economy.

Second, by building on this model we present empirical evidence on how the cost of capital impact

caused by the coinsurance effect can be disentangled from the impact caused by the diversification

discount. For this purpose, we use a dataset of US Mergers & Acquisitions (M&As) over the period

1985 to 2014 in which the buyer acquires 100% of the target firm and for which we are able to measure

the cost of capital for the acquirer and the target before the takeover and for the merged firm afterwards.

As expected, the coinsurance effect causes a decrease in the cost of capital, while the diversification

discount leads to an increase.

Third, these effects are economically important and statistically robust. For example, a firm with an

efficient internal capital market that increases its diversification through a merger by the sample mean

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