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The Conglomerate Discount: A New Explanation Based On Credit Risk

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  • MANUEL AMMANN

    (Swiss Institute of Banking and Finance, University of St. Gallen, Rosenbergstrasse 52, CH-9000, St. Gallen, Switzerland)

  • MICHAEL VERHOFEN

    (Swiss Institute of Banking and Finance, University of St. Gallen, Rosenbergstrasse 52, CH-9000, St. Gallen, Switzerland)

Abstract

We present a simple new explanation for the diversification discount in the valuation of firms. We demonstrate that, ceteris paribus, limited liability of equity holders is sufficient to explain a diversification discount. To derive this result, we use a credit risk model based on the value of the firm's assets. We show that a conglomerate can be regarded as an option on a portfolio of assets. By splitting up the conglomerate, the investor receives a portfolio of options on assets. The conglomerate discount arises because the value of a portfolio of options is always equal to or higher than the value of an option on a portfolio. The magnitude of the conglomerate discount depends on the number of business units and their correlation, as well as their volatility, among other factors.

Suggested Citation

  • Manuel Ammann & Michael Verhofen, 2006. "The Conglomerate Discount: A New Explanation Based On Credit Risk," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 9(08), pages 1201-1214.
    • Handle: RePEc:wsi:ijtafx:v:09:y:2006:i:08:n:s0219024906004025
    DOI: 10.1142/S0219024906004025
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    Cited by:

    1. Nadine Gatzert & Hato Schmeiser, 2011. "On the risk situation of financial conglomerates: does diversification matter?," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 25(1), pages 3-26, March.
    2. Parvinder Arora & Qian Long Kweh & Deepanker Mahajan, 2018. "Performance comparison between domestic and international firms in the high-technology industry," Eurasian Business Review, Springer;Eurasia Business and Economics Society, vol. 8(4), pages 477-490, December.
    3. Grass, Gunnar, 2010. "The impact of conglomeration on the option value of equity," Journal of Banking & Finance, Elsevier, vol. 34(12), pages 3010-3024, December.

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