Disentangling value: Financing needs, firm scope, and divestitures

This paper presents a rationale for divestiture consistent with one of the reasons frequently cited by divesting firms, namely, that the firm is under valued and splitting the firm into its component businesses will make it ea sier for the market to value the components accurately. When firms are unde rvalued due to unobservability of divisional cash flows, they may resort to divestiture to raise capital while overvalued firms will use external equi ty. Diversification thus might result in costly future divestiture. Firms t rade off this expected cost of diversification against the benefit of highe r levels of cheaper internal capital in deciding the scope of the firm. Jou rnal of economic Economic Literature Classification Numbers: D82, G34, L22. (C) 1999 by Academic Press.