Active Asset Markets, Divestitures and Divisional Cross-Subsidization

Abstract

This paper develops a model which shows that when divestiture activity takes place in the backdrop of an active asset market, divisional cross-subsidies emerge even in the absence of agency problems between managers and shareholders. In our model, the incentive to cross-subsidize arises because firms attempt to window-dress the performance of divisions that are likely candidates for sale. Since in equilibrium, the prospective buyers are not misled, window-dressing results in a deadweight loss. An early divestiture avoids this deadweight loss and consequently improves firm value. This theory of cross-subsidization is consistent with existing empirical results reporting value gains on asset sales and relating these gains to increases in focus. An additional empirical prediction of our model is that the performance improvement of the remaining divisions would be greater when assets are sold in periods of relatively high takeover activity in the divested unit?s industry. We test this prediction and find consistent results.

JEL Classification: G31, G34, M41