Monthly Archives: January 2012

Topic 9: Do spin offs create value for shareholders?

Spin off refers to the act of separating a unit of a larger organization and establishing it as a separate business. Just like mergers and acquisitions are carried out under the belief that the combination of two entities may generate a new entity whose value is greater than the sum of the parts, at the opposite end of the spectrum, spin offs are carried out when a firm believes that its overall value would increase if one of its components were separated and established as an individual entity. When a spin off is carried out, shareholders of the parent company are typically compensated for the decrease in value of their holdings after the spin off with a quantity of shares of the new entity proportional to their holding of shares of the parent company. From an investor’s point of view, the advantage brought about by a spin off is the ability to manage separately the exposure to different businesses: for instance, investors would have benefited from the proposed spin off of the personal computer division of HP in the sense that this would have enabled them to make distinct decisions about their exposure to the enterprise software business of the parent company and to the hardware business of the spun off unit (Menn and Palmer, 2011). In addition to this, shareholders may benefit from the fact that while the assets of the unit are transferred entirely to the new entity, the parent company remains liable for the debt of the old entity.

But is there empirical evidence on the benefits of spin offs? A broad range of empirical studies demonstrate that both the mother company and the spun off unit on average increase in value after being separated; while such research has traditionally focused on developed markets (Veld and Veld-Merkoulova, 2004), research has recently found similar results in developing markets. Md Hamid (2010), for instance, has analyzed 25 corporate spin-offs in Singapore and has quantified the overall benefit as an increase in the value of the parent company by 15.73 percent. This is made up of a 6.62 percent increase, which accrues to the spun off unit, and a 9.11 percent increase that accrues to the original firm.

Having established the existence of benefits for both parties, how do spin offs exactly create value for shareholders? Berger and Ofek (1995) have found extensive evidence of the existence of a discount in the stock price of the conglomerate, compared to individual units; a spin off thus appears as a straightforward method to redeem the value embedded in the organization. In this context, it is suggested that the increase in value in the spun off unit is brought about by the increase in business focus of the single firm.

Schipper and Smith (1983) suggest that efficiency tends to improve in the spun off unit because shareholders can supervise more closely senior management than they could do in a conglomerate context; in this sense, they find that asymmetric information exists between the managerial team of a conglomerate and the market. In this sense, spin off may be a good solution to manage agency issues within an organization.

Siddiqi and Warganegara (2003) find that spin offs are a good solution to ensure efficient capital allocation: within a multi-divisional firms, a unit with high growth opportunities may be unable to obtain the capital it requires due to the existence of political behavior and asymmetrical information. The likelihood of a spin off increases with the growth differential between the unit itself, and the rest of the organization. As this grows, the opportunity cost of capital misallocation increases and will eventually offset the efficiencies brought about by the lower borrowing rate on offer to the conglomerate.

Further research from Pyo (2007) indicates that changes in executive compensation have an important role in creating value in a spin off unit, particularly where management is replaced during the spin off process. He finds evidence that pay-performance sensitivity increases in spun off units and that spin offs are used as opportunities to establish new systems of managerial compensation.

In addition to this, spin offs may increase the value of a unit by changing the way in which it accesses the market. For instance, AMR Corporation, parent company of American Airlines, is currently planning the spin off of its loss making regional franchise American Eagle (Lemer, 2011). The most important consequence for American Eagle in its spin off from AMR would be its ability to operate as an independent airline with an independent value proposition in the market. Currently, a large quantity of customers may be avoiding American Eagle due to its alignment with American Airlines; in a competing environment like the American one, dominated by alliance networks, a regional airline with poor economics like American Eagle may struggle to attract customers due to the alliance that it belongs in. Once it will be spun off, American Eagle will be able to provide regional connections to a number of network carriers, thus exploiting synergies. A good example of this is Alaska Airlines, that has maintained its independent status to avoid being restricted by the partnership with a carrier.

So why do conglomerates still exist? Conglomerates create value by exploiting synergies between the units they are made up of, often bringing together very different types of expertise. Talking about Siemens, for instance, the Economist (2010) notes:

“It [Siemens] can, for example, audit a company’s energy use and suggest improvements that will then pay for themselves out of savings. Many rivals already do this. But few offer to finance the capital spending and guarantee the energy savings, as Siemens does.”

However, the competitive landscape changes quickly and companies need to maintain a flexible approach to their portfolio of activities. In this sense, just like mergers and acquisitions allow companies to respond to changes in competitive landscapes by adding to their portfolio, spin offs allow them to release competences that have become redundant within the strategic jigsaw.



  • Berger, P.G. and Ofek, E. (1995). Diversification’s effect on firm value. Journal of Financial Economics, 37, p.39–65;
  • Economist (2010). Siemens: A giant awakens, The Economist, 9th September.
  • Hollowell, B. (2009). The long-term performance of parent firms and their spin-offs. The International Journal of Business and Finance Research, Vol.3(1), p.119-129;
  • Lemer, J. (2011). American Eagle closer to spin off from AMR. Financial Times, available online at ;
  • Md Hamid, U. (2010). Corporate spin-offs and shareholders’ value: evidence from Singapore. The International Journal of Business and Finance Research, Vol.4(4), p.43-58;
  • Menn, J. and Palmer, M. (2011). HP chief hails PC unit despite spin-off plans, Financial Times, available online at ;
  • Pyo, U. (2007). Enhancing Managerial Incentives and Value Creation: Evidence from Corporate Spinoffs. Journal of Economics & Finance, Vol.31(3), p.341-358;
  • Schipper, K. and A. Smith, (1983). Effects of Recontracting on Shareholder Wealth: The case of voluntary spin-offs. Journal of Financial Economics, Vol.12(3), pp. 437-467;
  • Siddiqi, M. and Warganegara, D. (2003). Using Spinoffs to Reduce Capital Misallocations. Review of Quantitative Finance and Accounting, Vol.20(1), p.35-47;
  • Veld, C. and Veld-Merkoulova, Y. (2009). Value Creation Through Spin-offs: A Review of the Empirical Evidence. International Journal of Management Reviews, Vol.11(4), p.407-420.


Topic 7: On dividends and shares buy backs.

Dividend policy is one of the most debated issues in finance: although much research has been done to investigate the existence of a superior dividend payout policy, a clear cut answer has not emerged, with evidence that is at times contradictory.

The debate revolves around three main standpoints: those that argue that paying dividends increases the value of a firm, those that argue that it decreases the value of a firm and those that argue that it has no impact on a firm’s value.

Proponents of the first hypothesis claim that investors have a natural preference for stocks that provide high returns and that cash is best returned to investors, rather than left to the company’s management, that may or may not invest it in projects that increase the future profitability of the firm.

Those that argue against high dividend payouts note that taxation on dividends is heavier than on capital gains, and in this sense the latter is a more efficient way for firms to provide returns to investors. Proponents of low, or even zero dividend payouts are generally in favour of shares buybacks as a way to return funds to investors.

Finally, a third group sees dividends as the difference between capital expenditure and retained earnings (capital expenditure is netted out of the portion that can be financed through debt). If the firm wants to increase its dividend payout to investors beyond the difference between retained earnings and capital expenditure, it must issue new shares that end up diluting the value of the shares owned by the investor that received the increased dividend. The two effects offset each other, leaving the firm’s value unaffected (and an investor can always reinvest his or her dividend to avoid dilution).

Research such as that from Arnott and Asness (2003) found evidence against the claim that high earning retention leads to an increase in the growth rate of future earnings. In this sense, their research is consistent with the claims of high payout proponents, according to whom management may end up engaging in empire-building activities with retained earnings, and that these are better off returned to investors. On the contrary, subsequent research from Ap Gwilym, Seaton and Thomas (2005) has found that high-dividend portfolios with a high payout ratio and zero-dividend portfolios do not outperform each other on a risk-adjusted basis. This is consistent with the third hypothesis set out above. Given the impossibility of resolving the dividend policy debate through empirical evidence, it may be useful to accept the heterogeneity that exists in the market, where different stocks have different dividend policies and turn our attention to the dynamics that drive dividends. Here evidence is a less ambiguous. First of all, there is strong evidence that dividends are sticky, i.e. that payouts lag behind earnings by several periods. Research from Brav, Graham, Harvey and Michaely (2005) on a sample of nearly 400 executives of listed firms found that dividends are not set independently as a result of earnings, but that the majority of executives set dividends in relation to level of the previous year, often adjusting other decisions to avoid lowering dividends. This idea has been modeled by Guttman, Kadan and Kandel (2010) as dividend pooling: they advance the hypothesis that a certain dividend level is not linked to the specific earnings attained over the period, but rather to a range of different values. In this sense, executives display a bias against change in dividend levels, particularly when the adjustment should occur downwards. Executives motivate this choice with the beliefs that stock prices have an in-built premium that reflects dividend stability, and that not smoothing dividends across periods would damage stock price. Chariotu, Lambertides and Theodoulou (2011) also find evidence that dividend stability is beneficial: they find that a firm with a strong record in terms of profitability and dividend payment that posts a loss, is more likely to return to profitability in the next period if it does not suspend dividend payments. This argument is not entirely convincing however: it may be the case that firms that continue paying out dividends to investors do so because they know that their loss is occasional and will not impact their long run earnings. In this sense, causation may run in the opposite direction than hypothesized. Notwithstanding the direction of the causation between dividends and earnings, it is clear that investor see the dividend payout as containing precious information about a company’s financial health. In this sense, executives may decide not to begin paying dividends in the first place, in case they may not be able to sustain the same level of payout in the future. This partly explains a phenomenon that has been on the rise since the 1990s, share buybacks: firms have begun to retire a portion of their outstanding shares instead of returning capital to shareholders in the form of a dividend. The first objection to share buybacks refers to the fact that unlike dividends, they do not treat investors equally (Smith, 2011); however, share buybacks also benefit those shareholders that do not participate in the program because they decrease the number of shares outstanding and thus increase future earnings per share. Another popular objection to share buybacks refers to the fact that they often tend to occur when shares are trading at relatively high prices, and in this sense they are a suboptimal method of returning funds to investors. Some even argue that the increase we are currently observing is share buy backs (Demos, 2011) is akin to managerial delinquency because executives are often paid in share options that are profitable only when the stock price goes above the strike price. In this sense, while paying dividends they would be effectively lowering the price of the stock, and thus their chance of making a profit from their options, by retiring some shares, they are effectively lowering the supply of the firm’s stock on the market and increasing its price.

On balance, without clear evidence on the impact of dividends on a firm’s value, dividends policy is likely to remain a matter of executive choice; executives and investors have a preference for stability and in this sense dividend smoothing remains a widely adopted practice among those companies that pay dividends regularly. Those that do not, are unlikely to begin to pay dividends in the near future given the uncertainty they face; as mentioned above, shareholders value dividend stability and it may be difficult for executives to suspend dividend payments without impacting the share price. In this sense, even though they are not without shortcomings, share buybacks represent an increasingly attractive way to return create value for investors not only because they can be easily terminated, but also because they are a relatively easy way to increase earnings per share in a stagnant operating environment.



  • Ap Gwilym, O. Seaton, J. and Thomas, S. (2005). Dividend Yield Investment Strategies, the Payout Ratio and Zero-Dividend Stocks. The Journal of Investing, Vol. 14(4) p.69-74;
  • Arnott, R. and Asness, C. (2003). Surprise! Higher Dividends = Higher Earnings Growth. Financial Analysts Journal, Vol. 59(1), p.70-87;
  • Brav, A. Harvey, C. Graham, J. and Michaely, R. (2005). Payout Policy in the 21th Century: The Data. Johnson School Research Paper Series No. 29-06. Available at SSRN:;
  • Charitiou, A. Lambertides, N. and Theodoulou, G. (2011). Losses, Dividend Reductions, and Market Reaction Associated with Past Earnings and Dividends Patterns. Journal of Accounting, Auditing & Finance, Vol. 26(2), p.351-382.
  • Demos, T. (2011). Surge in buy-backs by US companies, Financial Times, available online at;
  • Guttman, I. Kadan, O and Kandel, E. (2010). Dividend Stickiness and Strategic Pooling. Review of Financial Studies, Vol. 23(12), p.4455-4495;
  • Smith, A. (2011). Companies dig into share buy-backs. Financial Times, available online at

Topic 5: Capital structure: trade off theory vs. pecking order theory

The capital structure of a firm refers to the mixture of equity and debt that the firm employs to finance itself. The crucial issue in terms of deciding the right capital structure for a firm is to identify the combination of equity and debt that maximizes the market value of a firm; where this is maximized, the company minimizes the cost of its capital.

Modigliani and Miller have famously demonstrated how, under a very specific set of assumptions, the capital structure of the firm does not affect its value. This finding has been subsequently overturned due to the unrealistic nature of its assumptions, such as the absence of taxes, risk, bankruptcy costs, asset characteristics and asymmetric information. Unfortunately such elements have a bearing in the context in which firms operate on a daily basis: for instance, the cost of financing a firm’s debt is tax deductible and bankruptcy has both direct (e.g. litigation) and indirect (e.g. lost business) costs. On these facts rests the first of the two mainstream theories used to conceptualize capital structure, the so-called trade off theory: debt is typically cheaper for a firm to service because it does not imply any form of risk-sharing and it can be collateralized, unlike equity that is a residual claim. In this sense, a firm can lower its weighted average cost of capital, at least initially, through leverage. Leveraging, however, also increases the financial risk of the firm that must service its debt regularly, unlike its equity. In this sense, a firm must balance the benefit brought about by the lower average cost of capital against the increase in financial risk: trade off theory identifies the optimal debt-to-equity ratio as the level at which the two offset each other.

The second theory used to conceptualize capital structure is the so-called Pecking Order Theory, according to which firms prefer to finance themselves internally through retained earnings; when this source of financing is not available, the company issues debt and only in the last instance does it issue equity. This is due to the type of message that the different type of securities send to the market: while debt signals to investors that management are confident that they can service the debt, equity signals that management believe the firm to be overvalued and could potentially trigger a fall in its share price. In this sense, pecking order theory analyses capital structure from a point of view rooted in agency theory, and describes financing decisions as potentially affected by managerial attempt to minimize supervision from shareholders.

Empirical research has found conflicting evidence on the ability of these theories to explain how firms go about their financing decisions; nonetheless, it has substantially improved our understanding of the factors that influence capital structure. Psillaki and Daskalakis (2009), for instance, find evidence consistent with pecking order theory, specifically that leverage tends to be positively correlated with the size of a firm and the portion of its assets that are tangible, whereas it tends to be negatively correlated with its profitability and risk. More profitable firms can finance their capital expenditure internally instead of raising capital externally, as predicted by pecking order theory. The firms surveyed by Psillaki and Daskalakis (2009) all belong in what Bancel and Mittoo (2004) define as a French Law system, and in this sense the findings from the former are consistent with predictions from the latter that differences in the legal system explain differences in capital structure between legal systems. Bancel and Mittoo (2004) find evidence that supports the hypothesis advanced by La Porta et al (1998) that more advanced legal systems provide higher creditor protection, which lowers agency costs and increases the availability of debt capital.

Even though the research described above has provided useful evidence that aids our understanding of capital structure determinants at the micro level, at the macro level the debate on capital structure remains dominated by the trade off theory versus pecking order theory argument. Given the impossibility of resolving this argument, it is interesting to look at attempts to reframe this debate. Agca and Mozumdar (2004), for instance, have argued that the theories should not to be thought of as conflicting but as complementary:

“[the] conflicting nature of the existing evidence on the pecking order theory is due to the difference between financing practices of large and small firms, and the skewness of the firm size distribution. The theory performs poorly for small firms because they have low debt capacities that are quickly exhausted, forcing them to issue equity. The pecking order theory performs satisfactorily for large firms, firms with rated debt, and when the impact of debt capacity is accounted for” (2009).

In this sense, they find that trade off theory considerations help firms determine their debt capacity, while pecking order theory describes firms’ preferences between different methods of financing. Pecking order theory seems to explain satisfactorily the financing behavior of larger firms, but not of smaller firms, that are constrained by their limited borrowing capacity. The explicit distinction that this model makes between smaller and larger firms seems like a sensible addition; a firm’s size is an overriding variable that has important consequences for the extent to which the firm has access to capital markets. Another interesting model on capital structure links it to the firm’s dividend policy (Faulkender, Mulbourn and Thackor, 2006): they argue that the better past performance, the higher is agreement between management and shareholders. This in turns leads shareholders to accept a less favourable capital allocation vis a vis management: they accept a lower dividend payout, which in turn translates in higher cash reserves at the firm and thus a lower leverage ratio. They find empirical support for their hypothesis and argue that it explains why firms like Microsoft did not pay any dividend and did not take on debt for a long period of time: returns to investors are represented by the increases in share prices that accrue thanks to the high level of agreement.

Overall, the debate over capital structure is unlikely to be resolved in terms of predominance of one of the two theories prevailing over the other, if anything because there are a larger amount of elements that have to be factored into the equation than those that appear in the theories outlined above: whilst it is important for a capital structure to minimize the weighted average cost of capital, such considerations have to be balanced against considerations of flexibility, for instance, that are even more important in today’s operating environment. In this sense, the existence of multiple theories on capital structure, as opposed to one, may in fact be beneficial.



  • Agca, S. and Mozumdar, A. (2004). Firm Size, Debt Capacity, and Corporate Financing Choices. Available online at ;
  • Bancel, F. and Mittoo, U. (2004). Cross-Country Determinants of Capital Structure Choice: A Survey of European Firms. Financial Management, Winter 2004, p.103-132;
  • Faulkender, M, Milbourn, T. and Thakor, A. (2006). Does Corporate Performance Determine Capital Structure and Dividend Policy? Available online at ;
  • La Porta, R., Lopez-de-Silanes, F., Shleifer, A., Vishny, R., (1997). Legal determinants of external finance. Journal of Finance, Vol. 52, p.1131-1150;
  • Psillaki, M. and Daskalakis, N. (2009). Are the determinants of capital structure country or firm specific? Small Business Economics, Vol. 33 (3) p.319-333.

Topic 3: On diversification

Asset risk is usually thought of as being made up of two components: diversifiable risk and systemic risk. The former type of risk is asset-specific because it results from the individual characteristics of the asset: for instance, in the case of a company’s stock, the asset-specific risk refers to the consequences of a bad product launch, a recall or a loss of market share. This type of risk is diversifiable through portfolio selection: by combining together different assets, an investor can reduce the variability of his or her portfolio without necessarily sacrificing expected returns. Systemic risk, instead, refers to the potential downfall brought about by the fact that a particular asset is embedded in a wider system: in the case of a bond, such risk may be represented by an increase in interest rates or inflation that reduces the real rate of return.

Although it is not possible to diversify entirely systemic risk, the asset classes as well as geographic areas in which one can invest have grown significantly in recent years, shifting part of the risk that used to fall under systemic risk into diversifiable risk. For instance, while a few decades ago most investors would have been unable to diversify the risk of being exposed to their domestic market, globalization has opened up new markets and allowed investors to diversify to a higher degree.

Diversification seems a no-brainer, and perhaps rightly so: but what are the limits and risks of diversification? As described above, diversification reduces the variance of a portfolio and does so through what in statistics is called regression to mean: as the sample size increases, the likelihood that the mean of the observations take on an extreme value decreases. By combining different assets with the same expected return, an investor can lower the variance of his or her portfolio without necessarily impacting expected return. However, empirical evidence suggests that diversification may, after all, impact returns: Ivkovic, Sialm and Weisbenner (2008), for instance, find that “wealthy households holding highly concentrated portfolios perform significantly better than the wealthy households holding widely diversified portfolios”. Although a formal investigation of this phenomenon is beyond the scope of this entry, it is interesting nonetheless to speculate about the mechanisms that may come at play with diversification. Research from Citi estimates the number of stocks that need to be included in a portfolio for it to be effectively diversified as high as 25 to 30 (Mincer, 2008). In this sense, diversification involves holding a significant number of different assets. In addition to this, the same research also found that over the previous two decades, only 10% of the stocks of the S&P 500 achieved returns consistently higher than the index over a three-year period. However, the proportion of stocks that the same study found to have underperformed the index by at least 15% in any year is as high as a third. Even though the way in which the results are presented makes it hard to compare them, the research seems to indicate that by selecting a stock at random from the index, it is more likely that the investor select an underperformer than an overperformer. In this sense, it may well be that as they increase the number of different assets they hold, investors end up purchasing lower-quality assets, with a negative impact on the expected return of their portfolio. Even though diversification remains one of the basic principles of portfolio theory, it is useful to explore its potential hidden costs.

The recent financial crisis also seems to have rebalanced the concept of risk in investors’ minds: after experiencing almost a decade of relatively stable markets, where crises were mostly sector-specific, many investors had discounted the systemic portion of risk and, as a result of this, overestimated the benefits of diversification. One of the main shortcomings of diversification has been identified with the fact that correlation increases significantly:

“One of the most striking features of 2008 was the fact that correlations between most asset classes went up substantially: everything declined at the same time. One of the principal motivations behind diversifying is that all of your holdings will not decline at the same time. Declines in one class will be buffered by gains in another—or at least lesser losses in others. This effect has not provided much buffer in 2008.” (Consildine, 2009)

In this sense, it is important to realize that diversification is designed with normal market conditions in mind and this may significantly limit its effect under extraordinary market circumstances. A similar hypothesis had been advanced even before the current financial crises by Butler and Joaquin (2001) that had pointed out the limits to international diversification. In this sense, it may be beneficial to expand the way we think about diversification and adopt a more holistic, multi dimensional approach to in order to manage portfolio risks (note the plural) more effectively. Diversification has traditionally been intended in terms of variance, but an investor may be interested in other features of his or her portfolio. For instance, an investor may want to diversify his or her portfolio along the liquidity spectrum, to ensure performance is appropriately balanced with exit options.

Not only does diversification have more dimensions that the one described in textbooks, but it may be something different than we think altogether. The recent financial crisis seems to have made a permanent mark on the markets, that are increasingly dominated by irrationality and wild swings. If this is a sign that, in fact, the dynamics that drive asset prices are less deterministic than we think as argued by Taleb, then investors are really left at the mercy of markets and diversification may just be a recognition of this.


  • Butler, K. and Joaquin, D. (2001). Are the gains from international portfolio diversification exaggerated? The influence of downside risk in bear markets. EFMA 2002 London Meetings;
  • Consildine, G. (2009). Opportunities in a High Correlation World. Available online at ;
  • Ivkovic, Z. Sialm, C. and Wiesbenner, S. (2008). Portfolio concentration and the performance of individual investors, Journal of Financial and Quantitative Analysis, Vol 43, No 3 pp. 613-656;
  • Mincer, J. (2008). Why it’s wrong to hold too much of one stock. Wall Street Journal, 4/9/08;
  • Taleb, N. (2001). Fooled by Randomness: The Hidden Role of Chance in the Markets and in Life. W. W. Norton.