THE JOURNAL OF FINANCE•VOL.LXII,NO.2•APRIL2007
Financial Synergies and the Optimal Scope of the Firm:Implications for Mergers,
Spinoffs,and Structured Finance
HAYNE E.LELAND∗
ABSTRACT
Multiple activities may be parated financially,allowing each to optimize its finan-
cial structure,or combined in a firm with a single optimal financial structure.We con-因式分解十字相乘法
sider activities with nonsynergistic operational cash flows,and examine the purely
financial benefits of paration versus merger.The magnitude of financial synergies
depends upon tax rates,default costs,relative size,and the riskiness and correlation
of cash flows.Contrary to accepted wisdom,financial synergies from mergers can
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be negative if firms have quite different risks or default costs.The results provide a
rationale for structured finance techniques such as ast curitization and project
finance.
D ECISIONS THAT ALTER TH
E SCOPE of the firm are among the most important faced by management,and among the most studied by academics.Mergers and spinoffs are classic examples of such decisions.More recently,structured finance has en explosive growth:Ast curitization exceeded$6.8trillion in2004,and Esty and Christov(2002)report that in2001,more than half of capital invest-ments with costs exceeding$500million were financed on a parate project basis.1Yet financial theory has made little headway in explaining structured finance.
Positive or negative operational synergies are often cited as a prime motiva-tion for decisions that change the scope of the firm.A rich literature address the roles of economies of scope and scale,market power,incomplete contract-ing,property rights,and agency costs in determining the optimal boundaries of the firm.2But operational synergies are difficult to identify in the ca of ast curitization and structured finance.
∗Hayne E.Leland is at the Haas School of Business,University of California.I would like to thank Greg Duffee,Benjamin Esty,Christopher Hennessy,Dwight Jaffee,Nengjiu Ju,Robert Novy-Marx,Erwan Morellec,James Scott,Peter Szurley,Nancy Wallace,Jof Zechner,and particularly Jure Skarabot and an anonymous referee.
1“Structured finance”typically refers to the transfer of a subt of a company’s asts(an “activity”)into a bankruptcy-remote corporation or other special purpo vehicle or entity(SPV/ SPE).The entities then offer a single class of curities(a“pass-through”structure)or multiple class of curities(a“pay-through”structure).Structured finance techniques include ast cu-ritization and project finance and are discusd in more detail in Section VI.See Esty and Christov (2002),Esty(2003,2004),Gorton and Souleles(2005),Kleimeier and Megginson(1999),Oldfield (1997,2000),and Skarabot(2002).
2Classic studies include Coa(1937),Williamson(1975),and Grossman and Hart(1986).See also Holmstrom and Roberts(1998)and the references cited therein.
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This paper examines the existence and extent of purelyfinancial synergies. To facilitate this objective,we assume that the operational cash flow of the combined activities is nonsynergistic.3If operational synergies exist,their effect will be incremental to the financial synergies examined here.
In a Modigliani-Miller(1958)world without taxes,bankruptcy costs,infor-mational asymmetries,or agency costs,there are no purely financial synergies, and capital structure is irrelevant to total firm value.In a world with taxes and default costs,however,capital structure matters.Therefore,changes in the scope of the firm that affect optimal capital structure typically create financial synergies.
Financial synergies can be positive(favoring mergers)or negative(favoring paration).When activities’cash flows are imperfectly correlated,risk can be lowered via a merger or initial consolidation.Lower risk reduces expected de-fault costs.Leverage can potentially be incread,with greater tax benefits,as first suggested by Lewellen(1971).However,Lewellen asrts that the financial benefits of mergers always are positive.If his asrtion is correct,then purely financial benefits cannot explain structured finance.But we show below that Lewellen’s argument is incomplete.Financial paration of activities—whether through parate incorporation or a special purpo entity(SPE)—allows each activity to have its appropriate capital structure,with an optimal amount of debt and equity.Separate capital structures and parate limited liabilities may allow for gr
eater leverage and financial benefits than when activities are merged with the resultant single capital structure.4We show that this is likely to be the ca when activities differ markedly in risk or in default costs.Further, as Scott(1977)and Sarig(1985)obrve,paration bestows the advantage of multiple limited liability shelters.
This paper develops a simple trade-off model of optimal capital structure to address three questions:
1.What are the characteristics of activities that benefit from merger versus
paration?
2.How important are the magnitudes of potential financial synergies?
3.How do synergies depend upon the volatility and correlation of cash flows,
and on tax rates,default costs,and relative size?
While operational synergies may exceed financial synergies in many mergers or spinoffs,financial synergies can be sizable in the specific situations that we identify.Indeed,financial synergies are often cited as the principal reason for structured finance,and our model shows potentially significant f写眼睛的词语
inancial bene-fits to using the techniques.The results have implications for empirical work 3The assumption that operational cash flows are additive,and therefore invariant to firm scope, parallels the Modigliani-Miller(M-M,1958)assumption that cash flows are invariant to changes in capital structure.While much of capital structure theory deals with relaxing this M-M assumption, it still stands as the ba from which extensions are made.
4The analysis considers a single class of debt for each parate firm.Multiple niorities of debt within a firm will not affect the results as long as all class have potential recour to the firm’s total asts.
Financial Synergies and the Optimal Scope of the Firm767 attempting to explain the sources of merger gains or to predict merger activity. Aspects of firms’cash flows that create substantial financial synergies,such as differences in volatility and differences in default costs,should be included as possible explanatory variables.
This paper is organized as follows.Section I summarizes previous work on financial synergies.Section II introduces a simple two-period valuation model. Clod-form valuation formulas when cash flows are normally distributed are derived in Section III,and properties of optimal capital s
tructure are consid-ered.Section IV introduces measures of financial synergies from mergers.Sec-tion V examines the nature and extent of synergies when cash flows are jointly normal.This ction contains our core results,including a counterexample to Lewellen’s(1971)conjecture that financial synergies are always positive.Sec-tion VI considers spinoffs and structured finance,providing examples that il-lustrate the benefits of ast curitization and project finance.Section VII considers the distribution of benefits between stockholders and bondholders. Section VIII concludes,and identifies veral testable hypothes.
I.Previous Work
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云南有什么特产Numerous theoretical and empirical studies consider the effects of conglomer-ate mergers and diversification.Lewellen(1971)correctly argues that combin-ing imperfectly correlated nonsynergistic activities,while not value-enhancing per ,has a coinsurance effect:Mergers reduce the risk of default,and thereby increa debt capacity.He then conjectures that higher debt capacity leads to greater optimal leverage,tax savings,and value for the merged firm.Staple-ton(1982)us a slightly different definition of debt capacity but also argues that mergers have a positive effect on total firm value.In Section V below we quantify the coinsurance effect,and show that it does not always overcome the disadvantage of forcing a single financial structure onto multiple activities. When the la
tter dominates,paration rather than merger creates greater total value.
Higgins and Schall(1975),Kim and McConnell(1977),Scott(1977),Stapleton (1982),and Shastri(1990)consider the distribution of merger gains between ex-tant bondholders and stockholders.They argue that while total firm value may increa with a merger due to lower risk,bondholders may gain at the expen of shareholders.Similar to Lewellen’s work,the papers do not have an ex-plicit model of optimal capital structure before and after merger.5Nonetheless, our results support many of their conclusions.
Examples in the papers above assume that activities’future cash flows are always positive.In this ca,limited firm liability has no value.However,Scott (1977)and Sarig(1985)independently note that,if activities’future cash flows can be negative,limited firm liability provides a valuable option to walk away 5Scott(1977)prents a simple two-state example in which capital structure is optimized,and shows that a profitable merger could result in lower total debt.
768The Journal of Finance
from future activity loss.6Mergers may incur a value loss in this ca:The sum of parate nonsynergistic cash flows,with limited liability on the sum,can be less(but never more)than the sum o
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f cash flows each with parate limited liability.Thus,although activity cash flows are additive,firm cash flows are subadditive.We term the loss in value that results from the loss of parate firm limited liability the“LL effect.”Its magnitude depends upon the distribution of activities’future cash flows,and is independent of capital structure.The LL effect is negligible in some of the cas that we examine.Yet it can be substantial under realistic circumstances.
Numerous papers consider the potential impact of firm scope on operational synergies.Flannery,Houston,and Venkataraman(1993)consider investors who issue external debt and equity to invest in risky projects and must de-cide upon parate or joint incorporation of the projects.They find that joint incorporation is more valuable when project returns have similar volatility and lower correlation,results that are consistent with our conclusions.However, operational rather than financial synergies drive their results:Investment and therefore the cash flows of the merged firm will be different from the sum of investments and cash flows of the parate firms.John(1993)us a related approach to analyze spinoffs,while Chemmanur and John(1996)u manage-rial ability and control issues to explain project finance and the scope of the firm.
Several recent papers u an incomplete contracting approach to determin-ing firm scope.Inderst and M¨uller(2003)assume nonverifiable cash flows and examine investment decisions.Separation of
activities may be financially desir-able,but only if there are increasing returns to scale for cond-period invest-ment.While cash flows are additive in the first period,investment levels and therefore operational cash flows in the cond period depend upon whether ac-tivities are merged(centralized)or parated(decentralized).Faure-Grimaud and Inderst(2004)also consider nonverifiable cash flows in the context of merg-ers.In contrast with our model,firm access to external finance is restricted becau of nonverifiability.Mergers affect the financing constraints and in turn future cash flows.Chemla(2005)introduces an incomplete contracting environment where ex post takeovers can affect ex ante effort by stakehold-ers,and therefore future operational cash flows are functions of the likelihood of takeover.Rhodes-Kropf and Robinson(2004)focus on incomplete contract-ing and ast complementarity(implying operational synergies)in explaining merger benefits.They find empirical evidence that similar firms merge.Our ,Proposition1in Section V.C)suggest that financial synergies could also explain the merger of similar firms.
Morellec and Zhdanov(2005)u a continuous time model to consider merg-ers as exchange options.Positive operational synergies are assumed but are not explicitly examined;their focus is on the dynamic evolution of firm values and the timing of mergers.
Finally,numerous papers consider the effect of mergers on managerial deci-sion making.Agency cost
s may give ri to negative operational synergies and 6Sarig(1985)cites the potential liabilities of tobacco and asbestos companies as examples of cas in which activity cash flows can be negative.
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Financial Synergies and the Optimal Scope of the Firm769 a“conglomerate discount.”7A rich but still inconclusive empirical literature tests whether such a discount exists.8
The purely financial synergies we examine are in most cas supplemental to,rather than competitive with,the existence of operational synergies.The works cited above generally ignore optimal capital structure and the resulting tax benefits and default costs that are the key sources of synergies in this paper. Our approach is simple:Information is symmetric,cash flows are verifiable, and there are no agency costs.Despite its lack of complexity,our model shows that financial synergies can be of significant magnitude,and it provides a clear rationale for ast curitization and project finance.
II.A Two-Period Model of Capital Structure
The analysis of financial synergies requires a model of optimal capital struc-ture.This ction develops a simple two-period model to value debt and equity. The approach is related to the two-period models of DeAngelo and Masulis (1980)and Kale,Noe,and Ramirez(1991).In contrast with the
authors,we distinguish between activity cash flow and corporate cash flow,since the latter reflects limited liability and is affected by the boundaries of the firm.Also in contrast with the authors,our analysis makes the more realistic assumption that only interest expens are tax deductible.This,however,creates an endo-geneity problem.When interest only is deductible,the fraction of debt rvice attributed to interest payments depends on the value of the debt,which in turn (when the tax rate is positive)depends on the fraction of debt rvice attributed to interest payments.We u numerical techniques to find debt values and opti-mal leverage.But the lack of clod-form solutions limits the comparative static results that can be obtained analytically.
A.Operational Cash Flows,Taxes,and Limited Liability of the Firm Consider a risk-neutral environment with two periods t={0,T},where T is the length of time spanned by the two periods.The(nonannualized)risk-free interest rate over the entire time period T is r T.An activity generates a random future operational cash flow X at time t=T.Following Scott(1977)and Sarig (1985),future operational cash flows may be negative.
Risk neutrality implies that the value X0of the operational cash flow at t= 0is its discounted expected value;that is
aiming7See,for example,Jenn(1986),Aron(1988),Rotemberg and Saloner(1994),Harris,Kriebel, and Raviv(1982),Shah and Thakor(1987),John and John(1991),John(1993),Li and Li(1996), Stein(1997),Rajan,Servaes,and Zingales(2000),and Scharfstein and Stein(2000).Maksimovic and Philips(2002)focus on inefficiencies(that generate negative cash flow synergies)of conglom-erates in a model that does not include agency costs.
8Martin and Sayrak(2003)provide a uful summary of this rearch.Berger and Ofek(1995) document conglomerate discounts on the order of15%.This and related results have been chal-lenged on the basis that diversified firms trade at a discount prior to diversifying:e,for example, Lang and Stulz(1994),Campa and Kedia(2002),and Graham,Lemmon,and Wolf(2002).Mansi and Reeb(2002)conclude that the conglomerate discount of total firm value is insignificantly different from zero when debt is priced at market rather than book value.
