Divisional Informativeness Gap and Value Creation from Asset Sales

Published date01 November 2016
Date01 November 2016
The Financial Review 51 (2016) 559–578
Divisional Informativeness Gap and Value
Creation from Asset Sales
Chintal A. Desai and Manu Gupta
VirginiaCommonwealth University
Nanda and Narayanan (1999) show that the information asymmetry between the managers
and market participants regarding divisional cash flows helps explain the value creation on
asset sales. Based on their theoretical framework, the divisional informativeness gap hypoth-
esis predicts that the announcement-period return increases with the difference in cash-flow
informativeness of retained and divested divisions prior to the divestiture. Our results, using
industry-average earnings response coefficient as a proxy for cash-flow informativeness of
a division, support this prediction. The effect is stronger when a conglomerate retains the
division with relatively greater growth opportunities.
Keywords: asset sales, divestitures, cash-flow informativeness, corporate restructuring
JEL Classifications: G34, G14
1. Introduction
In an asset sale, the conglomerate divests a division, subsidiary, or product line.
Nanda and Narayanan (1999), hereafter NN, show that the information asymme-
try between the managers and the market regarding the divisional cash flows can
cause undervaluation of a two-division firm. In their model, the difference in cash-
Corresponding author: Department of Finance, Insurance and Real Estate, School of Business, Virginia
Commonwealth University, 301 West Main Street, Richmond, VA 23284; Phone: (804) 828-7175; Fax:
(804) 828-3972; E-mail: mgupta2@vcu.edu.
C2016 The Eastern Finance Association 559
560 C. A. Desai and M. Gupta/The Financial Review 51 (2016) 559–578
flow informativeness of divisions is the key driver of undervaluation, and hence,
the source of wealth gain on an asset sale. We form the divisional informativeness
gap hypothesis based on the theoretical framework of NN, which predicts that the
announcement-period return increases with the difference in cash-flow informative-
ness of the retained and divested divisions prior to divestiture.1The objective of this
research is to test this prediction using a sample of U.S. divestitures.
We estimate the divisional informativeness gap of a conglomerate by first iden-
tifying the three-digit Standard Industrial Classification (SIC) code of the divested
and the retained divisions based on their business operations for the year prior to
the asset sale. Then, we perform an ordinary least squares regression of earnings-
announcement abnormal-return on earnings surprises for all firms with the same
three-digit SIC code as the given division. The residual of this regression is the noise
in cash-flow informativeness of a division. The divisional informativeness gap is the
absolute difference between noise of cash-flow informativeness of the retained and
the divested divisions.
Our results, based on a sample of 242 asset sales for the period 1990–2010,
support the divisional informativeness gap hypothesis. The asset sale announcement-
period abnormal returns increase with the difference in cash-flow informativeness of
divisions prior to the asset sale. This effect is stronger for a conglomerate that retains
the division with relatively greater growth opportunities.
The NN model is built on two key assumptions. First, firms sell assets to finance
an investment opportunity of the retained division. There is empirical support to this
assumption. Hovakimian and Titman (2006) empirically show that the cash from
a voluntary asset sale is an important determinant of the firm’s future investment
expenditure. Borisova and Brown (2013) find evidence that the cash from asset sale
is useful for financing future research and development expenditure. Second, the
market participants are unable to observe a division’scash flow for a given period. In
reality,the firms must report performance information of segments that represent 10%
or more of consolidated sales. However, we can still not eliminate the possibility of
cross-segment shifting of earnings and expenses. Managers are likely to manipulate
divisional cash flows to avoidreporting losses of a particular division as losses attract
more external monitoring (Hann and Lu, 2009). Chen and Zhang (2007) show that the
undervaluation of a conglomerate is a result of industry wide cross-segment shifting
of earnings. They show that a superior quality firm divests a businessunit to separate
itself from industry peers, and thus overcomes undervaluation.
Our research makes two contributions to the corporate finance literature. First,
it identifies additional source of shareholders’ wealth gains on asset sales. Second,
it uses a measure based on the industry-level earnings response coefficient for the
divisional informativeness gap of a conglomerate.
1In the next section, we review the related literature on asset sales and conceptually explain how the NN
framework helps form the divisional informativenessgap hypothesis.

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