Capacity overhang and corporate disinvestment decisions

• Published date: 01 September 2023
• Author: Ilker Karaca,Travis R. A. Sapp
• Date: 01 September 2023
• DOI: http://doi.org/10.1111/jfir.12333

Received: 5 February 2022

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Accepted: 3 May 2023

DOI: 10.1111/jfir.12333

ORIGINAL ARTICLE

Capacity overhang and corporate disinvestment

decisions

Ilker Karaca|Travis R. A. Sapp

Ivy College of Business, Iowa State

University, Ames, Iowa, USA

Correspondence

Travis R. A. Sapp, Ivy College of Business,

Gerdin Business Bldg. Room 3362, 2167

Union Drive, Iowa State University, Ames,

IA 50011‐2027, USA.

Email: trasapp@iastate.edu

Abstract

We use a stochastic frontier model to estimate a firm's

capacity overhang. We find that excess capacity is

positively related to a drop in new capital expenditures,

an accumulation of depleted long‐term assets, and

outright sales of investment assets. However, the sale

of long‐term assets (property, plant, and equipment

[PP&E]) peaks for intermediate levels of excess capacity

and then declines. We attribute this to growth options.

We test for evidence of a preference ordering in the

firm's choice of responding to excess capacity and find

evidence for a pecking order in firm disinvestment,

where sales of long‐term assets are a measure of

last resort.

JEL CLASSIFICATION

G12, G24, G30

J Financ Res. 2023;46:825–847. wileyonlinelibrary.com/journal/JFIR

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825

This is an open access article under the terms of the Creative Commons Attribution‐NonCommercial‐NoDerivs License, which

permits use and distribution in any medium, provided the original work is properly cited, the use is non‐commercial and no

modifications or adaptations are made.

© 2023 The Authors. Journal of Financial Research published by Wiley Periodicals LLC on behalf of The Southern Finance

Association and the Southwestern Finance Association.

Ilker Karaca may be reached at Ivy College of Business, Gerdin Business Bldg. Room 3235, 2167 Union Drive, Iowa State University, Ames, IA 50011‐

2027, Phone: (515) 294‐9553, Fax: (515) 294‐3525, email: ikaraca@iastate.edu. Travis R. A. Sapp may be reached at Ivy College of Business, Gerdin

Business Bldg. Room 3362, 2167 Union Drive, Iowa State University, Ames, IA 50011‐2027, Phone: (515) 294‐2717, email: trasapp@iastate.edu.

1|INTRODUCTION

How do firms respond to excess capacity? The literature on asset sales tends to focus on distressed firms and

mostly considers divestitures as an aggregate independent variable, whereas the literature on operating leverage is

mainly focused on asset pricing questions.

1

An exception is Schlingemann et al. (2002), who examine corporate

divestitures and find that both poor performance and liquidity are important considerations in asset sales. Given the

gap in the literature on the issue of corporate disinvestment, there are many unanswered questions to explore. How

should we measure the optimal capacity and any potential divestiture of assets? What types of adjustment

mechanisms does the firm use? Is there any evidence that firms divest assets to respond to capacity overhang, and

if so, at what point? Do firms show a preference ordering in their disinvestments?

In this study, we focus on the excess capacity, measured as technical inefficiency, of the cross section of all

public US firms from 1998 to 2017, and examine the linkages between capacity overhang and the firm's choice in

response to such inefficiencies. We employ several measures of disinvestment and asset sales to explain the role of

capacity overhang in influencing the firm's choice of disinvestment and divestitures. We show that commonly used

aggregate measures of divestitures are missing the association between corporate divestment strategies and firm

excess capacity.

2

By conditioning on excess capacity, the firm's disinvestment choices can be better understood.

We study how firms respond to inefficiencies in capacity use levels in two steps. First, we rely on a relatively

new and innovative capacity overhang variable to capture the firm's level of inefficiency in using its installed

capacity. The firm's capacity overhang measure is constructed using the stochastic frontier model proposed by

Aretz and Pope (2018). Their method produces a firm‐level estimate of the difference between a firm's installed

production capacity and its optimal capacity. They are the first to introduce this framework into a finance setting,

and we are the first to exploit their proposed measure of technical inefficiency to study how firms deal with excess

capacity. Second, we identify and examine several measures of asset growth, disinvestment, and outright

divestitures for both tangible and intangible assets to see how they relate to the firm's level of capacity overhang.

We also test for a preference, or “pecking order,”in the firm's divestment decision.

We can view the firm's disinvestment choices from a real options perspective. As a firm's capacity overhang

may both increase its operating leverage (and thus the sensitivity of earnings to the business cycle) and offer

valuable divestment options that decrease its business risk, disinvestment choices are expected to differ in their

potential option values. First, each of the identified disinvestment mechanisms has varying degrees of irreversibility

should the firm wish to revert to its predivestiture capacity levels. Both difficulty of implementation and, in the case

of an asset sale, illiquidity play a role. Second, such frictions are expected to cause considerable variation in the

values of alternative disinvestment options. For example, a firm's capacity overhang, coupled with irreversibility,

may cause the firm to tap into outright asset sales only as a measure of last resort, suggesting the presence of a

pecking order in corporate disinvestment. Such option values are expected to be higher for firms with relatively

higher intangible asset ratios. Firms that are research and development (R&D) intensive, for example, are expected

to respond more slowly to capacity overhang via the proposed disinvestment mechanisms.

We find that a firm's excess capacity i s positively related to a slowdown in new capital expenditures and to outright

sales of a firm's investment assets. Firms cut capital expenditures below a replenishment rate and accumulate deferral of

reinvestment in response to capacity overhang. However, results show that the tendency to sell long‐term assets

(property, plant, and equipment [PP&E]) reaches a peak for intermediate levels of capacity overhang and then declines.

1

For papers on how firms handle financial distress, see Eckbo and Thorburn (2008), Shleifer and Vishny (1992), and Pulvino (1998).

Recent work on operating leverage, real options theory, and the value premium has shown that a firm's capacity‐related decisions

can explain value and investment anomalies in stock returns (Carlson et al., 2004; Cooper & Haltiwanger, 2006; Guthrie, 2011;

Hackbarth & Johnson, 2015; Sagi & Seasholes, 2007; Zhang, 2005).

2

For example, Fama and French (2006,2015) and Hackbarth and Johnson (2015) use change in total assets to measure firm

investment and disinvestment. Schlingemann et al. (2002) focus on a reduction in the number of reported business segments to

measure disinvestment, and Lambrecht and Myers (2007) examine takeovers of the entire firm as a disinvestment mechanism.

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JOURNAL OF FINANCIAL RESEARCH