Strategic Corporate Finance: Applications in Valuation and Capital Structure

PRACTICAL IMPEDIMENTS TO DIVESTITURE

Despite the real opportunity for tremendous value creation, several practical impediments exist to corporate divestiture activity. We outline how earnings dilution, confusion over value creation, fear of shrinking the business, book losses, and executive compensation each play a role in inhibiting corporate divestitures.

Earnings Dilution

Many executives are reluctant to divest unwanted businesses because of earnings dilution. This is especially true for large, mature, low-growth, cash cow businesses even though they fail to earn their cost of capital and may be worth more to a different owner or under a different ownership structure. We illustrate the math of multiple expansion in the face of dilution from a divestiture. A high price-to-earnings ratio (P/E) parent divests a low P/E subsidiary, reducing earnings per share (EPS). The multiple expands because the earnings reduction is disproportionate with the reduction in intrinsic value.

Table 3.2 shows that a parent company that spins off its low multiple business faces significant earnings dilution and multiple expansion. The larger the divested subsidiary, the more likely the impact will be material in terms of earnings dilution and in terms of multiple expansion. In the case of a split-off, share count is managed through the exchange process, providing more attractive cosmetics, much in the same way that a reverse stock split would achieve if executed on the heels of the spin-off. Alternatively, ...