Why Hang on to Losers? Divestitures and Takeovers

The author studies the divestiture decisions of managers who care about their reputations. Managers' divestiture and investment decisions are publicly observable, but managers privately observe signals with respect to the future payoff distribution of investments they have initiated. He establishes that in equilibrium there is too little divestiture. These inefficiencies create the opportunity for wealth-enhancing divestiture-motivated takeovers. A key result is that only managers of targets with "middle of the road" asset specificity should consider the takeover threat credible. These findings suggest that uniqueness of assets is an important determinant of both agency costs and takeover activity. The author's analysis leads to several empirical predictions. Copyright 1992 by American Finance Association.