Corporate Finance 49

CORPORATE FINANCE

Agency Problems, Equity Ownership, and

Corporate Diversification
David J. Denis, Diane K. Denis, and Atulya Sarin
Journal of Finance
vol. 52, no. 1 (March 1997):13560
Corporate diversification causes a loss of market value
for the firm. The authors find evidence that the loss of
market value is an agency cost. As the degree of
managerial ownership rises, the degree of corporate
diversification falls. They also find that external corporate control events often precede the divestiture of
corporate segments.

Recent evidence suggests that the costs of corporate diversification outweigh the benefits. The authors test the hypotheses that
managers receive private benefits from diversifying lines of business and that the resulting loss of market value is, therefore, an
agency cost. They also test the hypothesis that effective monitoring of corporate activity reduces the degree of diversification and
thus reduces those agency costs.
Berger and Ofek (Journal of Financial Economics, 1995), Lang
and Stulz (Journal of Political Economy, 1994), and Servaes
(Journal of Finance, 1996) find significant losses in market value
resulting from corporate diversification. Managers, however, may
receive private benefits from diversification in the form of prestige, added compensation, or job security. If managers do receive
those benefits, then the loss of market value associated with diversification is an agency cost borne by the shareholders.
David J. Denis and Diane K. Denis are at Purdue University. Atulya Sarin
is at Santa Clara University. The abstract was prepared by Robert A.
McLean, CFA, the University of Alabama at Birmingham.
The CFA Digest Fall 1997

50 Corporate Finance

The authors use the Value Line universe of firms and restrict their
sample to those firms that had sales of at least $20 million and no
sales in the financial services or regulated utilities industries in
1985, as reported in COMPUSTATs Industry Segment file. The
resulting sample includes 933 firms. They draw data on equity
ownership from the firms last proxy statements prior to December 1984. To measure diversification, the authors use (1) the fraction of firms with multiple segments, (2) the number of segments
reported by management, (3) the number of four-digit SIC codes
that COMPUSTAT assigns the firm, (4) a revenue-based Herfindahl index, and (5) an asset-based Herfindahl index. Finally, the authors use Berger and Ofeks measure of the excess value
associated with diversification: the firms total market value (market value of equity plus book value of debt) minus the imputed
value of the firms segments as stand-alone businesses.
As managers share of equity ownership in the firm increases, the
managers bear a progressively larger share of the agency costs of
diversification. Therefore, the authors hypothesize that as managers share of ownership increases, the degree of diversification
will fall. They test this hypothesis and find a consistent negative
relationship between managers equity share and the degree of diversification.
Amihud and Lev (Bell Journal of Economics, 1981) suggest that
as managers ownership share increases, they will engage in more
diversification in order to reduce personal risk. The authors incorporate that hypothesis into their model by allowing the ownership
share/diversification to be nonlinear. They find some evidence for
Amihud and Levs hypothesis at very high levels of managerial
ownership. The authors note that this evidence applies to only 13
of the 933 firms in the sample. Thus, the vast majority of sample
firms fall into the category in which diversification is negatively
related to managerial ownership.
The authors determine that significant negative excess values are
associated with diversification, but they find little support for the
hypothesis that negative excess values change as the degree of
managerial ownership changes. Furthermore, the authors find that
Association for Investment Management and Research

Corporate Finance 51

changes in the degree of diversification are associated with significant negative excess value (resulting from diversification), corporate 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 managerial
ownership. The degree of diversification, however, falls as the degree of managerial ownership (and, therefore, the degree to which
managers bear agency costs) rises. External corporate control
events, which indicate enhanced market monitoring, often precede
decreases in diversification.

The CFA Digest Fall 1997