Research Paper Summary James D. Rosenfeld Relation between Divestiture Announcements and Shareholder Wealth

James D. Rosenfeld, “Additional Evidence on the Relation between Divestiture Announcements and Shareholder Wealth,” Journal of Finance, Vol. 39, December 1984, pp. 1437-1448

Summary by

Himagiri Gedela
PGDIE 36, NITIE

A Divestiture is an alteration of the firm’s productive asset portfolio and is accomplished by either spinning-off or selling-off the unwanted assets.
The current paper presents estimates of the effect of voluntary divestiture announcements on shareholder wealth. The purpose of the paper is to provide further evidence regarding the impact of voluntary spin-offs and sell-offs on share holder wealth, in addition to the evidence found from the Earlier studies.
Some earlier studies[1,2,3] suggest that “Spin-off announcements have a positive influence on common-stock prices around the day of the event, while another study[4] suggests a far weaker response which the author contrasts with in the current paper.
The author finds that both types of divestitures have a significantly positive influence on share prices and that the spin-offs “outperform” the sell-offs over the announcement period. Unlike the merger studies that show that acquiring firms tend to “break even” on the transaction, the current study shows that the economic gains to both groups of share holders are virtually identical.


Motives underlying divestitures
The Goal of financial management is to maximize owner wealth; the firm should not undertake a divestiture unless the transaction is expected to benefit its shareholders.
Sell-offs
1. Sales price exceeds the present value of the divested asset’s future Net Cash Flows (NCFs).
2. Desire to sell unprofitable ventures while the buyer has a competitive edge over the seller (e.g., in manufacturing or marketing) which makes future NCFs more from buyers perspective. (Such projects are called as Positive NPV projects for both the parties).
Interpreting divestitures as a positive signal should have positive influence on share prices.
A negative signal, such as a need for cash to maintain corporate solvency, would have opposite effect on share holders wealth.
The signaling effect could either reinforce or dampen the investment effect.
Spin-offs
1. Elimination of negative synergies to increase future NCFs.
2. An alteration of the divested unit’s tax status to increase future NCFs.
3. For proper allocation (improving investment decisions) to enhance the value of divested assets.
4. May erode the position of bondholders causing a wealth transfer to stock holders while leaving the value of the firm unchanged.
5. Creation of publicly traded firms results in new information sources which enable shareholders to closely monitor the activities of managers, thereby reducing agency costs and enhancing share holders wealth.

Research Design
Focus: Comparison of each event’s influence on the stock prices of both the divesting and, in case of sell-offs, acquiring firms.
Samples for Spin-offs:
1. 93 firms over the period of Jan 1963 to Dec 1981
2. Shortlist of firms with divested property of at least 10% of market value of it’s common stock (Since large spin-offs have larger effect on share prices – study by Miles and Rosenfeld)
3. Elimination of firms with involuntary spin-offs and not listed on NYSE or ASE
The final list consists of 35 firms with 35 spin-off events.
Samples for Sell-offs:
1. Firms engaged in sell-offs over the period of Jan 1969 to Dec 1981
2. List restricted to Large (as followed for spin-off samples) Voluntary sell-offs
The final list consists of 62 firms with 62 sell-off events (11 within 5 years prior to the study and none within 1 yr)
Day 0 - Initial public announcement date of the firm’s intention to divest - taken as the day when it appeared in the Wall Street Journal.
Computation of Abnormal Returns:
Approach – Mean-Adjusted-Return (MAR)
Comparison period = day -150 through day -31 (Chosen to facilitate comparison with ABK study)
Observation period= day -30 through day +30
Step 1: Calculate Average Daily return over the comparison period (CPR). Acts as proxy for Expected daily return for the observation period.
Step 2: Adjusted Daily returns = Daily returns over the observation period - CPR
Step 3: For each trading day of the Observation period, Average Adjusted Return,
Step 4: Cumulative Average Adjusted Return for day d,
Step 5: t-tests performed using the Crude Adjustment Method (CAM) to take into account any cross-sectional dependence of the abnormal returns over the observation period.

Analysis of Abnormal Returns
1. Effect of Event Announcement on shareholders wealth
Salient observations from the analysis are given in the following table:
As per efficient market theory, the announcement affect should be fully and immediately impounded in security prices. Hence, CAAR over day -10 through day 0 is taken as more reliable indicator of the event’s influence than that of day -30 through +30.
The t-tests on the above CAAR observations over the period day -10 through day 0 suggest a statistically significant difference at 1% confidence level in favor of spin-offs.
2. Negative news Vs CAAR during observation period
Simultaneous release of negative news along with the sell-off announcement would tend to dampen the strength of announcement effect. Also, low quality (financial condition) firms’ divestiture announcements are more likely accompanied by less favorable corporate news.
Hypothesis: There will be a positive relationship between an issues S&P rating one year after the event and the magnitude of CAAR over selected intervals.
Testing the Hypothesis:
Step 1: Categorization of firms
Step 2: Comparison of CAARs over selected intervals adjusted for Quality rating for both events
Observations:
1. Wide differential among the CAARs of the three classes for both spin-offs and sell-offs.
2. All three classes of sell-offs produce similar CAARs over the day -1 through day 0
This suggests that, for the high-quality issues, more favorable news is being released during the observation period. And it is concluded that forming subsamples based on S&P rating should yield more valid comparisons between sell-offs and spin-offs.

Conclusion: The above findings suggest that share prices of divesting firms tend to respond more favorably to spin-offs than sell-offs.
Note: As an Issue’s S&P rating may be an imperfect proxy for the type of corporate news released, additional testing using alternative surrogates seems necessary before drawing more definitive conclusions.

Effects on Buyers and Sellers
Investigation of corporate sell-offs is a natural extension to the research performed in the merger studies.
In mergers, The synergistic effects of business combinations can raise the value of corporate resources, thereby increasing shareholders wealth. Studies demonstrate that
1. The shareholders of the acquired firms, on average, incur significant economic gains while those of the acquiring firms tend to break even
2. The combined market value of both firms tends to increase over the announcement period.
Hence, the abnormal returns of the firms that acquired the divested assets are compared with those of the selling firms to determine the extent to which the two firms share in the synergistic effects of the combination.
Sample: 30 selling and 30 acquiring Firms listed on CRSP tape where the purchase price was at least 10% of the market value of acquiring firm’s equity
Observations:
1. CAARs almost identical for selling and acquiring firms over the full observation period
2. Striking similarities between CAARs of the two samples over most of the sub intervals
3. Difference between the samples are statistically not significant
These finding suggest that both the acquiring firm and acquired assets have unique resources that earn positive economic rents when combined with the assets of the other firm.

Conclusions
From the above observations made during the study, the author concludes that
1. The announcement effect of spin-offs has a stronger positive influence on share prices than sell-offs.
2. Sell-off announcements, on an average, are perceived by share holders as a positive NPV transaction.
3. The share holders of both acquiring and divesting firms share nearly equally in the transaction and the transaction’s synergistic effects are not restricted to the selling firm.

References
1. James Miles and James Rosenfeld, “The effect of Spin-off Announcements on Shareholder Wealth,” Journal of Finance 38, December 1993, pp. 1597-1606;
2. Gailen Hite and James Owers, “Security Price Reactions around Corporate Spin-off Announcements,” Journal of Financial Economics 12, December 1983, pp. 409-436;
3. Katherine Schipper and Abbie Smith, “Effects of Recontracting on Shareholder Wealth: The case of voluntary spin-offs,” Journal of Financial Economics 12, December 1983, pp. 437-468,
4. Gordon Alexander, P. George Benson and Joan Kampmeyer, “Investigating the valuation Effects of Announcements of Voluntary Corporate Sell-offs,” Journal of finance 39, June 1984, pp. 503-517.