Investment Opportunities, Liquidity Premium, and Conglomerate Mergers

This paper analyzes the implications of diversification strategies and conglomerate mergers for the cost of capital in a model where the cost of capital depends on liquidity. We show that in a finitely liquid market with asymmetrically informed investors, both the benefits and the costs of diversification can be related to two characteristics of a firm’s investment opportunities. The benefits come from a reduced liquidity discount in the stock price of the merged firm when its shareholders anticipate less informed trading. The costs are the result of less efficient investment by the merged firm’s divisions due to a less informative stock price. The benefits and the costs vary with the return and risk of the investment opportunities of the firm’s divisions. Our results can explain the life cycle of diversification strategies that many firms experience. They also provide new implications for evaluating merger and spin-off candidates, and for understanding the trade-off between internal and external capital markets for capital allocations. JEL numbers: D82, G34, L22