diversifyingintobusinessesinwhichtheacquiringfirmhas
littleexpertisecanresultinlessefficientoperationsafterthe
merger (reverse synergy). Lang and Stulz (1994) present
evidencethatfirmsthatareinmultiplebusinessestradeata
discount of between 5 and 10 percent on individual firm
values and attribute this to a diversification discount.
11 Marketsseemtorecognizethefailureofdiversificationto
addvalue.Doukas,Holmen,and Travlos(2001)reportthat
marketsreactnegativelytotheannouncementsofdiversifying
acquisitions.
12
Theabsenceofaddedvaluefromadiversification-motivated
mergermayseempuzzling,giventhefactthatthetwofirms
are in unrelated businesses and thus should gain some
diversificationbenefit.Iftheearningsofthetwofirmsarenot
highlycorrelated,thevariancein earningsofthecombined
firm should be significantly lower than the variance in
earningsoftheindividualfirmsoperatingindependently.This
reductioninearningsvariancedoesnotaffectvalue,however,
becauseitisfirm-specificrisk,whichisassumedtohaveno
effectonexpectedreturns.(Thebetas,whicharemeasuresof
marketrisk,arealwaysvalue-weightedaveragesofthebetas
of the two merging firms.) But what aboutthe impact of
reduced variance on debt capacity? Firms with lower
variability in earnings canincrease debt capacityand thus
value.Thiscanbetherealbenefitofconglomeratemergers,
and we consider it separately later in this section.
Cash Slack
Managers may rejectprofitable investmentopportunities if
they have to raise new capital to finance them for two