why and how do firms divest-

The first key prediction of real options theory i.e., highuncertainty in a business unit’s environment deters its divestment, is empirically tested.Further, whether this deterring effect

WHY AND HOW DO FIRMS DIVEST?

DISSERTATION

Presented in Partial Fulfillment of the Requirements forthe Degree Doctor of Philosophy in the GraduateSchool of The Ohio State University

ByNaga Lakshmi DamarajuB.Sc M.B.A P.G.D.E.M L.L.B M.B.A M.S

* * * * *

The Ohio State University

2008

Dissertation Committee:

Professor Michael Leiblein

Business Administration Graduate Program

Copyright byNaga Lakshmi Damaraju

2008

This dissertation extends and examines the implications of real options theory—atheory that developed primarily in the context of investment decisions—in the context ofdivestment of business units In doing so, it challenges some of the existing ideas aboutdivestments—i.e., that firms’ unwillingness to divest may be due to agency reasons orthat divestments are a reactive response to poor performance at parent and/or businessunit levels Further, alternative explanations for divestments and divestment modechoices are considered along with explanations from the real options theory and therelative explanatory power of rival theories is established in this series of three closely-related essays All hypotheses are tested on a sample of divesting (298) and non-

divesting firms (596) that have been obtained from various sources following previousstudies

The first essay shifts the focus of real options theory from investment decisions todivestment decisions The key implications of the theory are developed and tested forbusiness unit divestments as ‘put’ options on real assets The results show that

uncertainty in a business unit’s environment is negatively related with the decision todivest Further, this negative relationship remains when environmental uncertaintyincreases and disappears when environmental uncertainty falls Together, these results

suggest that firms’ decisions to divest may be driven by option considerations when theenvironment of the business unit is uncertain.

While the first essay is about the decision to divest, the second essay followsclosely and is about divestment mode choices In the second essay, the relative

explanatory power of real options theory and information asymmetry is explored in thecontext of divestment mode choices In particular, it is tested whether staged divestmentsare more likely as compared to sell-offs due to 1) uncertainty in a business unit’s

environment and/or 2) information asymmetry about the true value of the business unit.The results show that information asymmetry explains staged divestments whereasuncertainty is irrelevant to divestment mode choice decisions This shows that whileexplanations exist for staged investments from a real options perspective, staged

divestments do not seem to follow a similar explanation Therefore, a separate ‘realoptions theory of divestments’ may be needed, rather than simply expecting the

predictions from ‘real options theory of investments’ to apply in the context of

divestments

The third essay is also related to the first two essays and focuses on the relativeimpacts of dynamic changes in uncertainty and information asymmetry on the decision todivest, per se While prior studies have examined explanations from real options theoryand information asymmetry separately, there could be an interesting linkage betweenthese two theories in the context of divestments While dynamic changes in uncertaintyhave been dealt with in the first essay, in the third essay the dynamic changes in

information asymmetry have also been considered to delineate the conditions where

iii

options thinking may have a dominating effect as compared to information asymmetryconcerns Results support the theoretical prediction that options considerations, undercertain conditions, may dominate information asymmetry concerns.

Together, these three essays represent an important extension of real optionstheory and improve our understanding of the divestment phenomenon

Dedicated to the Union Public Service Commission of India for rejecting me in 2001, thefailure that made me change direction and embark on this yet another journey of

excellence Further, this dissertation is also dedicated to the taxpayers in India and theUnited States whose moneys have been utilized for my education

v

I thank my mother—my first teacher and angel investor, and my father—anuncompromising perfectionist disciplinarian who wants me to win against all odds at alltimes, who have laid foundation for my personality and aspirations I learned

compassion and commitment from my mom, a very delicate person at heart I learnedlanguage, reasoning, debating, thinking, determination, outspokenness and selflessservice from my dad who is very true at heart, incredibly articulate and powerful inexpression I also thank my brothers Ramu and Anil, sister-in-law Latha, and my littlenephew Ganesh Srinivas, for taking care of things back home when I was away, withoutwhich this expedition to the United States would not have been a success These peopleare the locus of my existence

This dissertation also is the culmination of years of efforts, direct and indirect, ofseveral teachers who educated me The first, and as important as my mom and dad, is myprimary school teacher, Lalitha She gave me a lot of personal attention and sincerelybelieved that I was destined to achieve something great She had deep impact on mythinking at that early age My privilege to hoist the national flag in the school every year

on the Independence and Republic days sowed seeds of commitment to a career in theservice of my nation, an ambition that I pursued over the next 25 years of my life Ithank her for her dedication to the profession of shaping young minds and wish mycountry the good fortune of having such wonderful individuals in the years to come

I also thank my teachers at Pragathi High School, Hyderabad, India—Sarada,Rama, Satya, Shobha, Vidya, Mandakini, Saroja, Rajya Lakshmi, Rajeswari, SuryaPrabha, to name a few— who have provided a very nurturing yet a very challenginglearning environment during my adolescent years At this school, teaching was not abusiness It was a passion A sense of commitment to students’ holistic developmentpervaded its environs This shaped my philosophy of training, which eventually became

my profession I specially thank my mathematics teacher and a very good friend, Gopal,because of who I later majored in Mathematics, a subject that I would otherwise have notdared to venture into While mathematics never has been, nor will be, a subject of deep

interest to me, studying it taught me a core principle of learning—i.e., nothing is so

difficult to learn, if one really wants to learn it

My teachers—Rajya Lakshmi, Shyamala, Nirmala and Lakshmi—from

undergraduate college, Vanitha Maha Vidyalaya, have provided very valuable guidancewhen I was at cross-roads in terms of further education and career choices They

supported me when I wanted to embark on unfamiliar roads and advised that I should

pursue what I truly desired Rajya Lakshmi and Shyamala remained my personal

advisors ever since I sincerely acknowledge their contribution Dr LakshmikanthReddy, my marketing teacher at Badruka College, where I got my first MBA in 1994, isanother person who deserves an honorable mention

Any number of thanks will be insufficient to acknowledge another great

gentleman, Dr S Pratap Reddy, Principal-Director, Dhruva College of Management.Dhruva is a unique institution that provides a nurturing environment not only to its

vii

students, but also to its faculty members I learned the power of listening to an opposite

point-of-view with patience and disagreeing with respectfrom Dr Reddy (our Tiger) Heand his wife, Pushpa Latha Reddy, supported all my endeavors—whether it was pursuing

my dream of joining the Indian Administrative Services or pursuing education abroadlater on They were truly a phone call away to act on my requests to handle things backhome when I was in the Untied States I am not sure if I can ever repay their kindness Ihad the good fortune of serving this school for a decade as a faculty member and am nowextremely honored with an invitation to be on its governing council

It was at Dhruva that I met the person who changed the trajectory of my life—Dr.Rao H Unnava, Professor of Marketing at the Fisher College of Business, The Ohio StateUniversity Dr Rao is an incredible gentleman, a very fine teacher, and a true mentor Ithank him for his immense faith in my abilities when he advised me to join a PhD

program in the United States way back in 1999 Dr Rao’s entry into my life seems sopredetermined I picked up on his suggestion to come over to the U.S two years laterwhen I finally failed at getting my dream job and being a part of the administrativemachinery in my country I chose to get into the PhD program in Strategy at The OhioState almost five years after I first met him He was never impatient with me aboutwhich school I chose to go to or which subject I eventually wanted to pursue my PhD in

Dr Rao taught me, by example, a very important thing about advising—i.e., good

advisors give good advice and also leave enough latitude in implementation. He opened

a new window of thought in my mind…it became the window to the world He trulyworked in my best interest and is a mentor for life

Two other incredible mentors who paved my way to Dr Jay Barney at the OhioState University are Dr Gregory Dess and Dr Robert Kieschnick during my masters’program at the University of Texas at Dallas Dr Dess had a vision for me and has beenvery very affectionate He truly brought me back into academia, helped me make thedecision to pursue doctoral studies and encouraged me to go to an advisor who couldcontribute most to my interests As his TA, I got good training in academic writing andenjoyed great flexibility and independence He created my first copyrights and royalties.

He has been, and continues to be, a great source of encouragement and support

Dr Kieschnick, my finance professor and mentor, was always willing to discuss,gave time and attention, been affectionate and shaped my preliminary ideas that

eventually led to choosing the dissertation topic According to Dr Kieschnick, an

assistant professor’s tenure clock starts right at the time he/she joins the PhD program

He therefore thought I should be very well-prepared even before I got into it Both Dr.Dess and Dr Kieschnick wanted me to be prepared for a conversation with my advisor

the very first day I meet him That preparation helped me hit-the-ground-running when I

eventually joined the doctoral program at Fisher College I am deeply indebted them I

am also grateful to Jyothi Mallick, Director—Cohort MBA program and Professors,Joseph Picken, Constantine Konstans, Michael Oliff for their valuable recommendations,Mary and David Lawson and friends, Charul, Pranav, Arturo, Sherif, Bryan, Daniel (myCohort), Vinetta, Margie and Taylor Dess for keeping life going while at UTD

I also thank several Professors at the Ohio State University for their supportthroughout the PhD program Michael Leiblein, Mona Makhija, Jay Anand, Anil

ix

Makhija and Sharon James served on my committees and have been very supportive.Mona was the first professor I worked with at the Ohio State as a teaching assistant andshe has been a source of valuable advice at important times Anil’s corporate financeseminar helped me understand the nuances of empirical research in finance, an exercisethat proved very valuable for this dissertation He has been very encouraging and

supportive throughout the dissertation process Sharon Alvarez has been very warm,encouraging and supportive Konstantina Kiousis has been very friendly Dr

Greenberger, the department chair, has been very considerate and accommodated severalrequests Professors Miyazaki (Economics) and Omer Ozturk (Statistics) have been veryempathetic in tough times Professors Stephen Cosslett (Economics), Doug Schroeder,David Williams, John Fellingham (Accounting), Mike Fligner (Statistics), Dr Rao

Unnava (Marketing) also need to be specially acknowledged for their support during mydissertation Special thanks go to Jay Dial—an extraordinary teacher—who has takentime to educate me on fine-tuning my teaching style I also thank Roy Lewicki for letting

me attend his EMBA classes Professors Karolyi, Werner, Hirshleifer, and others fromFinance, Oded Shenkar (International Business), Steffanie Wilk and others from MHRhave also been very considerate of my questions and requests

Kathy, Heidi and Joan, our administrative support, have been immensely helpfuland are the best people I have seen in these roles They truly enjoy their jobs and havebeen very kind and nice Kathy had to have extraordinary patience in dealing with myseveral appointments, cancellations and rescheduling throughout this time and she hasalways been nice, warm, welcoming and helpful Shirley Gaddis (Marketing), Nancy

Ray (Entrepreneurship center), Mr Popovich (Librarian), Amy Richards and NaveenBaddam (Advising) have also been very kind on several occasions I also thank Councilfor Graduate Education in Business Administration and Hayes Forum for travel funding.

Throughout this journey, I enjoyed incredible support, trust and camaraderie ofseveral wonderful and very capable friends, who were also my very tough competitors

My high school buddies—Ravi, Padma and Raji, my friend from undergrad studies—Roopa and her family, my friends from MBA—Glory, Manohar, Chetan and Senthil, mycivil service buddies—Raghunath, Swarna and later Aparna (GMAT), have been with meregardless of success or failure and been my sponsors at several important times Padmaand her husband Raj have been of great support, both back in India and in the UnitedStates Roopa and Glory can be rightfully described as my ‘alter egos’ I truly cherishtheir friendship and owe them a lot for their faith in my decisions My very close friendand cousin NVK Rao, his wife Raji and their family are inextricably twined in this

journey Padma and Srinath, who consider me their daughter, are a very important part ofthe support network All these people know my aspirations and boosted my courage when

it was hitting rock bottom I cannot thank them enough My colleagues at Dhruva

College, Venu, Loknath, Aparna, Sailaja, Usha, Chakri, Suresh, Dashrath, Gopal andVeera have taken care of several issues back home when needed and truly deserve to bementioned My students at Badruka and Dhruva have been sources of fresh ideas andenthusiasm always Ramanathan, NIS-Sparta, my friend and guide from the corporateworld, has been very encouraging, helpful and supportive of my choices Ganesh Sharma,HDPI-HSBC, has also been a valuable source of advice at important junctures

xi

Added to these friends are Angie, Roger, Taylor, Rose and Jerome (Finance),Hammad and Ayesha (Economics), Vikas, Somnath and Sheenu (Statistics), Jenny andSandeep (Marketing), Nilesh, Anup, Doug, Alison, Ty and Asli (Strategy), Janice, Chad,Marie and Aden (MHR) at the Ohio State They entertained numerous questions and havebeen patient with me throughout the PhD program Susan, Charlie, Joe, Erin, Suresh,Sungho, Song, Yuping and Chris are valuable additions Sridhar (SAS consultant) hasbeen extremely generous in investing time and effort for training me in SAS and

continues to extend his professional expertise to my projects Hammad has been

extremely helpful with econometric modeling and been very willing to entertain mynumerous questions Angie, Anup, Sridhar and Hammad have truly been the

econometric and programming backbone for this dissertation

My friend Mary (OSU alumnus) and her family, Nilesh, Sujith, Jay Dial,

Sandhya, Sridevi (University village) and their families, Gopesh and Sowmya (UIUC),the Bendapudis, the Makhijas, the Unnavas, and my little roomies at 251 West 9th

Avenue —Ashwini, Shikha, Rimky and Vidya—have all been an important part of mysocial life in Columbus, OH Mary and her family helped with numerous moves, in rainand snow, have been very dependable and kept life under control I cannot imagine howlife would have been without Mary in Columbus She has been my ‘one-stop shop

solution’ for all questions and problems and is now a friend for life Professors TomLumpkin (TexasTech), Jay Janney (University of Dayton), Alan Eisner (Pace), MarilynTaylor (UMKC), Saikat Chowdhury (Wharton), Nandini Lahiri (UNC), Seung-Hyun Lee(UT Dallas) and my colleagues from other universities Manisha Singal (Virginia Tech),

John Upsom (Florida State), Ekin Alakent, Irem Demirikan, Ted Khoury and KiranIsmail Mirza (UT Dallas) have given valuable advice and been supportive at very

important times

Language has its limitations in capturing the range of human emotions I

experience this practically when I have to describe my gratitude to my advisor,

philosopher and mentor, Dr Jay Barney I discovered Jay Barney in my second semester

at UT Dallas, through his writings, and am very thankful to him for admitting me as hisstudent He exceeded my expectation for an advisor every time on every issue He is notjust an individual He is a philosophy…of life and research He is an interesting

Valuable, Rare, Inimitable combination of extreme levels of intelligence, great insight,genuine curiosity for exploring new ideas, deep compassion and affection for his

students….to say the least For him, research is an art and I can say he is a great artistand a very skilled trainer A friend advised me early on that if I do not see a twinkle inJay’s eyes when I describe an idea, then it is not worth pursuing him on it I had the goodfortune of seeing that twinkle quite a few times in the last couple of years It is

exhilarating

If Jay gets interested, it is like being with a play-mate He plays along and will beunbelievably flexible about the approach one takes to problems I am truly amazed at hisflexibility He is a great developer of his students’ abilities Without his flexibility, Icould not have overcome my aversion to programming and become a reasonably goodprogrammer It is also possible that I will venture into mathematical modeling sometime

xiii

Jay’s focus is extraordinary He X-rays through a 60-page paper to get to the coreproblem in a matter of seconds When he is at work, it is MEDITATION…nothingdistracts him When people get his time, they completely get it There are no phonecalls, no other conversations in between unless it is an overriding priority It may bequite a wait to get that time, but it is truly worth waiting for Speaking with him for a fewminutes always gave me direction for next 2-6 months Our conversation usually openedwith the incisive question “So, what have you got?” If I could not answer that question inthe quick 1-2 minutes, I would realize myself that I have not done my homework well Iquickly rescheduled in such instances and walked back to my office to prepare better.Talking to Jay for 2 minutes meant a couple of months of preparation This helped meget precise in expression and keep focus on the most important issues He is not a

‘hands-on’ supervisor That is his power I feel obliged to finish my work knowing verywell that he will not ask for it Time and distance do not matter when one works withJay…work gets done He is an academic Chief Executive….and it was my duty to

optimally utilize his time

On the other hand, when there was an emergency back home, in school, in coursework or anything, Jay was most willing to speak and resolve problems I never had anydifficulty getting his time He is not bureaucratic At several times when I was on thelow of the “PhD roller-coaster” (Jay’s description), he had the patience to hear me outand instilled confidence that I CAN DO IT I never, at such times, felt he was busy.When it was time for my proposal defense, dissertation, or job interview, he spent hourswith me on several days fine-tuning the presentations, papers and even my vita until it

was up to our satisfaction He really cares and is very nurturing I am extremely

privileged to have Jay as my GURU, a great role model, and truly cherish these fouryears of being his student Finishing at The Ohio State University only means the

beginning of life-long studentship with him and an intrinsically challenging career topursue ….there is no end to learning from Jay…there is no limit…

Finally, I thank God Almighty who continues to manifest himself in several ofthese human forms and enriches my life…Tamasoma Jyotirgamaya…in this journey fromdarkness to light…

xv

The University of Texas at Dallas

Concentration: Strategy

The University of Texas at Dallas

Concentration: Strategy

Osmania University, India

Post-graduate Diploma in Environment Management August, 1995Hyderabad Central University, India

Osmania University, India

Specializations: Marketing(1994) & Finance (1995)

Osmania University, India

Group: Mathematics, Physics & Chemistry

Qualified in the University Grants Commission’s National Eligibility Test for

Lecturership at University Level in India, December 1995

Fisher College of Business, The Ohio State University from Sep 2004

Graduate Teaching Assistant

Dhruva College of Management, Hyderabad, India Oct 1998 to Aug 2002

Badruka College PG Center, Hyderabad, India Jul 1994 to Mar 1997

Lecturer

PUBLISHED WORKDamaraju, N., Byrne, J C., and Eisner, A B 2004 Ford Motor Company in 2004:

Entering second century of existence In Dess, Lumpkin and Eisner, Strategic

Management, Text & Cases, second edition: 641-649 New York: McGrawHill-Irwin.

Damaraju, N., Gaetz, J R., Taylor, M L, and Dess, G G 2004 JetBlue Airways: Is

“High Touch Service” the key driver of JetBlue’s future success? In Dess, Lumpkin and

Eisner, Strategic Management, Text & Cases, second edition: 700-709 New York:

McGrawHill-Irwin (presented at the Society for Case Research Conference in KansasCity, 2004)

Damaraju, N., Gaetz, J R., Taylor, M L, and Dess, G G 2004 Southwest Airlines:

How much can ‘LUV’ do? In Dess, Lumpkin and Eisner, Strategic Management, Text

& Cases, second edition: 837-845 New York: McGrawHill-Irwin.

Damaraju, N 1999 The role of business schools in small & medium enterprise

development The Economic Times, Learning Management section, 05/02/1999.

Damaraju, N 1999 Role of leadership in franchisee management The Economic

Times, Learning Management section, 04/29/1999.

Mallikharjuna, C and Damaraju, N 1996 Management education A closer look In

Gautam V (Ed.), Learning Management: 202-205 New Delhi: Allied Publishers.

(Presented at a seminar sponsored by All India Council for Technical Education on'Planning and Management of Management Education in India' in 1995)

FIELDS OF STUDYMajor Field: Business Administration

Minor Field: Statistics

xvii

TABLE OF CONTENTS

Page

Abstract……… ii

Dedication……….v

Acknowledgments ……….vi

Vita………xvi

List of Tables……….xx

List of Figures………xxii

Chapters: 1 Introduction………1

2 Divestment as a real option: Firm choices under conditions of uncertainty… 6

2.1 Theoretical background……… 8

2.2 Theory development and hypotheses……….12

2.2.1 Uncertainty and divestments as ‘put’ options………12

2.2.2 Changes in the levels of uncertainty and the decision to divest…14 2.3 Method……… 16

2.3.1 Data………17

2.3.2 Other data sources……… 20

2.3.3 Variables and measurement……… 20

2.4 Analysis and results……… 29

2.5 Discussion and Conclusion………36

3 Uncertainty, information asymmetry and divestment strategies………54

3.1 Prior literature……… 56

3.1.1 Real options……… 56

3.2 Theory and hypotheses……… 61

3.2.1 Staged divestments: The options perspective……… 61

3.2.2 Staged divestments: The information asymmetry perspective… 62

3.3 Method……… 64

3.3.1 Rationale for the choice of methodology……… 64

3.3.2 Data……… 66

3.3.3 Other data sources……… 70

3.3.4 Variables and measures for the selection equation……… 70

3.3.5 Variables and measures for the outcome equation………78

3.4 Analysis and results……… 80

3.4.1 Summary statistics……….80

3.4.2 Selection equation results……… 82

3.4.3 Outcome equation results……… 84

3.5 Discussion and conclusion………86

4 When does information asymmetry matter to the decision to divest? 100

4.1 Prior literature……….102

4.2 Theory development and hypotheses……… 105

4.2.1 Information asymmetry and uncertainty: The constructs…… 105

4.2.2 The case of increasing environmental uncertainty and the impact of information asymmetry……… 108

4.2.3 The case of decreasing environmental uncertainty and the impact of information asymmetry……… 110

4.3 Method……….111

4.3.1 Data……… 115

4.3.2 Other data sources………119

4.3.3 Variables and measurement……….119

4.4 Analysis and results……….127

4.5 Discussion and conclusion……… 131

References………146

Appendix……… 155

LIST OF TABLES

2.3 Results from binary probit for the relationship between uncertainty and

the decision to divest……….45

2.4 Marginal effects from binary probit for the relationship between uncertainty

and the decision to divest……… 462.5 Probit results for sub-sample A (firms experiencing increase in uncertainty from

‘t-1’ to ‘t’)……… 472.6 Marginal effects for sub-sample A (firms experiencing increase in uncertainty

from‘t-1’ to ‘t’)……… 482.7 Probit results for sub-sample B (firms experiencing decrease in uncertainty from

‘t-1’ to ‘t’)……… 492.8 Marginal effects for sub-sample B (firms experiencing decrease in uncertainty

‘t-1’ to ‘t’)……… 502.9 Results from combined estimation using dummy variables……… 513.1 Summary statistics for divesting and non-divesting firms……….903.2 Summary statistics for firms engaging staged and complete divestments……….91

3.4 Main effects for selection and outcome equations from probit with selection… 943.5 Marginal effects for the selection equation………98

4.1 Summary statistics for divesting and non-divesting firms……… 134

4.3 Main effects for the case of increasing uncertainty in a business unit’s

environment……….1374.4 Marginal effects for the case of increasing uncertainty in a business unit’s

environment……….1394.5 Main effects for the case of decreasing uncertainty in a business unit’s

environment……….1414.6 Marginal effects for the case of decreasing uncertainty in a business unit’s

environment……….143

LIST OF FIGURES

2.1 Relationship between changes in levels of uncertainty and the

decision to divest……… 534.1 The case of increasing uncertainty and the impact of information asymmetry 1454.2 The case of decreasing uncertainty and the impact of information asymmetry 145

CHAPTER 1

INTRODUCTIONReal options theory has primarily been a theory of investments (Reuer and Tong,2007; Li et al., 2007) Two key predictions from real options theory that have been testedand supported time and again are: 1 firms would be deterred from making costly-to-reverse investments under conditions of high uncertainty (Campa, 1993; Guiso andParigi, 1999; Folta and O’Brien, 2004) and, 2 if investments were to be made underconditions of high uncertainty, staged/sequential investments will be preferred (eg., jointventures as opposed a complete investment) because they provide flexibility to deal withuncertainty (Kogut, 1991; Cuypers and Martin, 2007)

Real options theory is still nascent in the area of divestments (Li et al., 2007).There seems to be an implicit assumption that the predictions of real options theory, asdeveloped for investment decisions, will apply in the context of divestment decisions

This dissertation examines whether and to what extent do the predictions from real

options theory hold in the context of decisions to divest business units Further, theconditions under which this theory may have better or less explanatory power as

compared to rival theories are also examined

A dataset that captures information at both parent and segment levels is used totest the relevant hypotheses The dataset includes firms that have engaged in segment

divestitures and a control set of firms that have not engaged in divestments The sampleperiod is from1980 to 2004 All kinds of divestments i.e., spin-offs (where equity in adivested unit is issued to existing shareholders of a firm pro-rata), equity carve-outs(where equity in a divested unit is issued to new shareholders) and sell-offs (where thebusiness unit is completely sold and becomes a part of a different firm) are included

The first essay conceptualizes divestment of business units as real ‘put’ options(Dixit and Pindyck, 1995) The first key prediction of real options theory i.e., highuncertainty in a business unit’s environment deters its divestment, is empirically tested.Further, whether this deterring effect changes with changes in environmental uncertainty

is also examined

Probit models are used to tests these predictions Results show that, indeed, highuncertainty in a business unit’s environment has a significant negative association withthe decision to divest the business unit Also, an increase in uncertainty accentuates thisnegative association of uncertainty with the decision to divest whereas a decrease rendersuncertainty irrelevant to the decision to divest Together, these results show that firms’decisions’ to divest business units may be driven by option considerations, particularlywhen the conditions surrounding the divestment are uncertain This result holds aftercontrolling for all major theoretical explanations in the divestment literature

It will be expected that the second prediction from the real options theory aboutflexible modes of governance under conditions of uncertainty will also hold for

divestments as it does for investments However, an equally powerful argument for

staged divestments comes from the information asymmetry perspective According to thisperspective, firms engage in staged divestments to reduce information asymmetry andmaximize proceeds from sales (Zingales, 1995) The second essay builds argumentsfrom real options theory and information asymmetry for staged divestments and teststheir relative explanatory power

These hypotheses are tested using a probit model with selection correction Thismethod takes the two decisions—the decision to divest and the decision to divest in astaged manner—together and jointly maximizes the likelihood Possible selection effectsbetween non-divesting firms that could potentially impact the decision to divest in stagedmanner are accounted for The methodology also shows the close connection betweenthe first and second essays The first essay forms the theoretical basis for the selectionequation in the second essay

Results show that uncertainty is not significant to the decision to engage in stageddivestments This is a very interesting result because it highlights that real options theorymay not apply the same way to divestments, as it does in the case of investments

Therefore, it may be important to think of a ‘real options theory of divestments’ Further,information asymmetry has a significant positive association with the decision to engage

in staged divestments This shows that staged divestments may be means to mitigateadverse selection costs and maximize proceeds from sales under conditions of

information asymmetry rather than options to deal with high uncertainty

A third important question is about the relative importance of information

asymmetry and uncertainty to the decision to divest per se It has been argued that

information asymmetry has an adverse impact on the decision to divest (Myers andMajluf, 1984) Also as shown in essay 1, from a real options perspective, the decision todivest may be driven by options considerations under conditions of high uncertainty.However, information asymmetry may be less relevant to the decision to divest whenthere is a great deal of uncertainty about the information itself Therefore, uncertaintyand options considerations may dominate information asymmetry concerns, under certainconditions Current literature does not consider information asymmetry and uncertaintytogether to explore these relationships

The third essay brings these two competing theoretical perspectives together andexplores the dynamic relationships between information asymmetry and uncertainty Inparticular, under conditions of increasing uncertainty, uncertainty is expected to have adominating effect over information asymmetry Therefore, changes in the levels ofinformation asymmetry are not expected to change the lack of significance of informationasymmetry to the decision to divest On the other hand, under conditions of decreasinguncertainty, information asymmetry concerns are expected to surface Therefore,

changes in the levels of information asymmetry should matter More specifically, anincrease in information asymmetry is expected to strengthen the negative relationship ofinformation asymmetry with the decision to divest as compared to a decrease in

information asymmetry Further, even under conditions of increasing information

asymmetry, uncertainty is expected to be negatively related to the decision to divest, on

an average

These hypotheses are tested using probit analyses Results support the idea thatunder certain conditions, options considerations may be more important for the decision

to divest than concerns arising due to information asymmetry

Together these three essays thus make important contributions to the real optionstheory in general, and to divestment literature, in particular

CHAPTER 2DIVESTMENT AS A REAL OPTION: FIRM CHOICES UNDER CONDITIONS OF

UNCERTAINTY

Real options theory focuses on the need for flexibility under conditions of

uncertainty (Kogut, 1991) And, since strategic decisions are often made under

conditions of uncertainty, real options theory has found broad application in the strategicmanagement literature Mergers and acquisitions (Warner, Fairbank and Steensma,2006), joint ventures (Kumar, 2005; Reuer and Tong, 2005), entry into foreign markets(Gilroy and Lukas, 2006), entrepreneurial ventures (O’Brien, Folta and Johnson, 2003;McGrath, 1999) and other investment decisions have all been studied using a real optionanalog to a financial ‘call option’ i.e., the right to buy or invest in an asset at a future datewithout an obligation to do so

The key implications of options theory in the context of real assets—that firms are

be deterred from engaging in costly-to-reverse investments under conditions of highuncertainty and that investments are structured to deal with such uncertainty—have beenlargely corroborated (Chi and McGuire, 1996; Folta, 1998; Folta and Leiblien, 1994;Reuer and Leiblein, 2000; Kogut, 1991) Several other aspects of strategic investmentunder conditions of uncertainty— such as different options embedded in investmentdecisions (Kulatilaka, 1995), competitive considerations in options logic (Smit and

maximizing interests (Dixit and Pindyck, 1995) In this sense, the option to defer thedecision to divest—a ‘put’ option—can be valuable While some analytical work hasfocused on the option value associated with divestments under conditions of uncertainty(Dixit, 1992; Myers and Majd, 1990), empirical work has been more limited Much less

is known about the actual value created by such ‘put’ real options and how such optionsare exercised

In this paper, the key implications of these real ‘put’ options are developed andtested in the context of the divestment of business units In particular, the relationshipbetween the levels of uncertainty in a business unit’s environment and the likely decision

to divest and, how the value of the ‘put’ option changes dynamically with changes in thelevels of uncertainty, are examined Consistent with the findings of real options theory inthe context of investments, high environmental uncertainty was negatively associatedwith the decision to divest the business unit This supports the idea that divestments are

‘put’ options on real assets

With regard to the effect of changes in the levels of environmental uncertainty,when environmental uncertainty increased, uncertainty was still significantly negativelyassociated with the decision to divest On the other hand, when environmental

uncertainty decreased, uncertainty did not necessarily induce divestments That is,uncertainty, in this setting, was irrelevant to the decision to divest—indicating a loss of

‘put’ option value Therefore, the value of retaining the option to divest differs based onwhether uncertainty increases or decreases over time Together, these results support thenotion that a firm’s reluctance to divest may be driven by option considerations when theconditions surrounding divestments are uncertain

Real options theory originated in finance Myers’s (1977) seminal idea thatfirms’ discretionary investment opportunities can be viewed as ‘call’ options on realassets, analogous to financial call options, laid the foundation for this theory The

strategic management literature followed, with Kogut’s seminal work on joint ventures,focusing on the design of governance mechanisms for investments under conditions ofhigh uncertainty (Kogut, 1983; 1985; 1991)

Decisions to invest in real assets under conditions of high uncertainty are

analogous to financial ‘call’ options As with financial ‘call’ options, real options oninvestments are claims or rights to buy an underlying asset at a pre-determined price, on

or before a future date, without an obligation to do so For real options under conditions

of high uncertainty, call options are more valuable than an outright purchase By

‘waiting-to-invest’ or by investing ‘stage-wise’, rather than making costly-to-reverse

investments, firms gain flexibility—acquire ‘call’ options—on investment opportunitiesunder conditions of high uncertainty (Trigeorgis, 1988; Kogut, 1991) Such flexibilityallows firms to benefit from the upside potential ––exercising the call options and makingfull commitment— if situations turn favorable and be protected from downside losses ifsituations turn unfavorable Based on this logic, the key predictions of real options

theory for investment decisions are: 1 firms are deterred from engaging in

costly-to-reverse investments under conditions of high uncertainty, and, 2 flexible governancemechanisms will be chosen under conditions of high uncertainty

These key predictions from real options theory in the context of investment

decisions have been supported by a number of studies For example, Guiso and Parigi(1999) found in a sample of Italian manufacturing firms, that increasing uncertaintylowered firm-level planned investment scale Campa (1993) reported a negative

relationship between exchange rate volatility and the number of foreign entries into theU.S market These results support the first prediction Work on joint ventures andstrategic alliances as desirable governance mechanisms under conditions of uncertaintyare examples in support of the second prediction (Kogut, 1991; Chi, 2000;)1

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Other research on real options theory of investments includes work on: ‘growth options’ (Kogut, 1983; McGrath, 1997), ‘switching options’ (Kogut, 1983, 1985, 1989), option interactions within the context of same investment (eg., growth versus deferral options (Folta and O’Brien, 2004; Kulatilaka and Perotti, 1998; Leiblein and Zeidonis, 2007)) or in the context of different investments (eg., pharmaceutical alliances

as exploratory investments in real options (Vassolo et al., 2004)), the role of endogenous uncertainty and learning (Sanchez, 1993; Sanchez and Mahoney, 1996) Valuation implications of real options, however, are still a nascent area of study with mixed empirical evidence (Reuer and Tong, 2007) Interested readers may refer to Li et al, 2007 and Reuer and Tong, 2007 for extensive review of literature on real options and also guidance for future research.

Despite this growing literature on real ‘call’ options, there has been much lessresearch on real ‘put’ options Divestments are real ‘put’ options in the following sense.Financial ‘put’ options are rights to sell assets at a pre-determined price (exercise price),

on or before a future date, without an obligation to do so Put options, therefore, areprotections against falling asset prices If a situation turns favorable and prices rise, therewill be no need to exercise the put option One can benefit from the upside by retaining

or selling the assets at market prices On the other hand, if a situation turns unfavorableand prices fall, the ‘put’ option can be exercised and the asset can be sold at the pre-determined price, which is presumably higher than the market price This ensures

protection from downside losses

Similarly, ‘put options’ on real assets will also be valuable under conditions ofhigh uncertainty The key idea is that it might be valuable to ‘wait’ and retain the option,rather than divest, when the conditions surrounding divestments are highly uncertain(Merton, 1998; Myers and Majd, 1990) This allows flexibility to gain from the upsidepotential and simultaneously prevent costly-to-reverse losses if uncertainty were to

resolve in ways inconsistent with the decision to divest

Of course, analyzing divestments as ‘put’ options has attracted some researchattention Myers and Majd (1990) modeled project divestments as ‘put’ options, with thevalue of the ‘put’ increasing with increasing uncertainty According to Dixit (1992),divestments may not occur even though the underlying causes for investments no longerexist, and that such effects would be accentuated under conditions of high uncertainty andirreversibility Also, Dixit and Pindyck (1995) argued that irreversible divestments will

be deterred under conditions of high uncertainty Further, Chi and Nystrom (1995)suggested that greater endogenous uncertainty could lead to exit delays Kogut andKulatilaka (2001) argued that managers in highly volatile environments hesitate to

radically change their tightly-coupled organizations in the hope of better states of world

There has also been some empirical testing of these ideas A prominent empiricaltest infers the value of a firm’s abandonment options from its balance sheet and showsthat such options have a positive effect on firm value (Berger, Ofek and Swary, 1996).Other evidence comes from experimental studies by Bragger et al (1998) who find that

in a simulated economy, participants who received feedback with higher variabilitydelayed exit decisions longer and invested more often than participants who receivedfeedback with lower variability Vassolo, Anand and Folta (2004) suggested that, as abase case, one can expect a negative relationship between uncertainty and the exercise ofon-going options Therefore, exit will be deterred under conditions of high uncertainty.They test and support this hypothesis in the context of bio-tech alliances

On the other hand, despite the large and growing literature on the divestment ofbusiness units by corporations, the idea that such divestments are like ‘put’ options andtheir exercise may be deterred under conditions of high uncertainty, is yet to be examinedempirically This approach has several possibly important implications for the study ofdivestments For example, prior divestment research argues that poor divisional

performance leads to business unit divestment This may be because poorly performingunits can put financial pressure on the parent corporation and also distract managerialattention from more profitable businesses (Ravenscraft and Scherer, 1991; Chang, 1996;

Duhaime and Grant, 1984) However, under conditions of uncertainty, current divisionalperformance may not be a good predictor of future performance A real options approach

in this setting suggests that divestment may not be forthcoming, despite low levels ofcurrent performance

Also, much of the current literature on divesting business units attributes delays inthe divestment decision to vested interests within a firm (Cho and Cohen, 1997) or otheragency problems (Bethel and Liebeskind, 1993; Shimizu and Hitt, 2005) Organizationalinertia the inability of organizations to adapt quickly to changes in the external

environment is seen to stem, at least partly, from managers desire for status-quo andtherefore can be considered an agency issue A real options perspective suggests that,under conditions of uncertainty, it may make sense for a firm to delay making a

divestment decision and in so doing keep its ‘put’ real options open, and thus that suchdelays have nothing to do with agency problems

2.2.1 Uncertainty and divestments as ‘put’ options

As outlined earlier, business unit divestments can be conceptualized as ‘put’options on real assets (Myers and Majd, 1990) This is because when the conditionssurrounding divestments are uncertain, the true value of business units may not be

known, and their current value may not be a good indicator of their future value

Divesting business units under such conditions could lead to several costly-to-reverselosses, and also prevent firms from benefiting from emerging opportunities

If temporary market conditions were to dictate divestments, it could lead to loss ofhighly valuable tangible and intangible assets (Dixit and Pindyck, 1995) Such capitalmight have been acquired or built over long periods of time and may be very difficult orimpossible to regain once lost (Carruth, et al 2000; Dierickx and Cool, 1989) For

example, specialized human skills and key customer relationships could be hard to

reacquire; highly intangible assets such as brand image could be very difficult to re-buildonce lost Further, in case of closely related business units, divestment of one or morebusiness units could disturb valuable relationships and linkages across them Such

relationships may not be easy to re-establish if the previously divested business unitswere to be re-started All these costly-to-reverse losses make profitable resumption ofoperations difficult, even if market conditions were to improve

Even when there are no costly-to-reverse losses, divestments may still not bedesirable under conditions of high uncertainty This is because of the possible inability togain from upside potential For example, some technological breakthroughs could

generate unexpected synergies Firms may be unable to spot and capitalize valuablegrowth options—follow-on investment opportunities created by such synergies—oncethey are out of a particular business line Even more importantly, firms may lose access

to critical information when they get out of a particular business, even if they operate inother businesses in an industry Such loss of access can prevent them from reentering andcapitalizing on follow-on opportunities Also, competitors could gain access to suchopportunities and information disadvantaging firms’ in other related businesses as well

These competitive considerations could be as important, if not more important, fordivestment decisions as compared to investment decisions (Kester 1984; Smit and

Ankum 1993)

For these reasons, it might be worthwhile to wait rather than exit a business underconditions of high uncertainty i.e., treat divestments as ‘put’ options and deal with themflexibly as uncertainty evolves (Kogut, 1991) The value of such ‘put’ options will behigher when the uncertainty about the value of the underlying businesses is higher

If firms, consider divestment of businesses as ‘put’ options on real assets, then

Hypothesis 1: Firms are less likely to divest a business unit when there is highuncertainty in the business unit’s environment

2.2.2 Changes in levels of uncertainty and the changes in ‘put’ option value

The negative relationship of uncertainty with the decision to divest, at a particularpoint in time ‘t’, also varies depending on whether that uncertainty is lower or higher ascompared to a previous point in time ‘t-1—i.e., the option value changes with an increase

or decrease in uncertainty over time It would be easier to understand these dynamicrelationships with the help of Figure 1

From Figure 1, it can be seen that there are four possible situations for

understanding the relationship between uncertainty and the decision to divest, whenuncertainty changes over time Situations in cell 1 and cell 4 are not of interest in thisreal options context because they do not involve changes in uncertainty However,situations in cell 2 and cell 3, where there are changes in the levels of uncertainty from

‘t-1’ to ‘t’, are interesting for this analysis

Cell 2 is a case of increasing uncertainty from‘t-1’ to ‘t’ In this case, all

arguments made in the previous section about the need for flexibility and the option value

in delaying divestments under conditions of high uncertainty hold If anything, theoption value should be greater for firms in this situation, since they experience an

increase in uncertainty, as compared to those in Cell 3 that experience a decrease inuncertainty In Cell 3, uncertainty decreases In this setting, the value of a put option willdecrease, or may even completely disappear Taken together, these arguments suggest,

Hypothesis 2: Firms are less likely to divest a business unit when uncertainty inthe business unit’s environment increases than when it decreases

Of course, there are other factors—even within the real options framework—thatimpact the decision of a firm to divest a business unit under conditions of uncertainty.For example, both the “exercise price”—i.e., the price at which a divestment can occur—and the “spot price”—i.e., the value that a firm places on a business unit to the rest of itsorganization— impact the decision about whether or not to divest However, since thesefactors are difficult to measure and observe—especially in large sample archival

studies—they are not included in this discussion In looking at the relationship betweenchanges in uncertainty and the value of real ‘put’ options, the impact of these changes onthe strength of the relationship between uncertainty and the decision to divest is central,over and above the potential impact of the exercise and spot price on the decision todivest

2.3 Method

The probability that a firm engages in a divestment decision is estimated by aprobit In this method, the decision of the ith firm to divest or not divest depends on anunobservable utility index Iithat is determined by explanatory variables Xijin such a waythat the larger the value of the index Ii, the greater the likelihood that the firm engages in

a divestiture This index Iican be expressed as

Ii=β0+ βjXijwhere Xijrefers to the different independent variables in the model, with subscript ‘i’referring to the particular firm in question and subscript j=1…n refer to the independent

or explanatory variables in the model

This index is related to the actual decision to divest as follows If Y=1 for a firmengaging in divestiture of a business unit and Y=0 for a firm that does not divest at all, itcan be assumed that there is a critical threshold for each firm Ii* such that if Ii> Ii* thenthe firm divests and otherwise it will not This threshold Ii* is not observable However,

it can be assumed to be normally distributed with the same mean and variance With thisassumption of normality, the probability that Ii* is less than or equal to Ii can be

computed using the standardized normal CDF as

Pi=Pr(Y=1)=Pr(Ii*<= Ii)=F(Ii)= 1/√(2Π) ∫ e-t2/2dt

where the limits on integration run from (-∞, Ii] or alternatively (-∞, β0+ βjXij] and ‘t’ is

a standardized normal variable i.e, t~N(0,1) Iiis obtained by taking the inverse Ii=F

-1

(Ii)= F-1(Pi)= β0+ βjXij

in the finance literature on divestitures (Chen and Guo, 2005; Powers, 2003) Sell-offswere identified by dropped segments in a company’s portfolio matched against

announcements in the SDC database (Schlingemann, Stulz and Walkling, 2002) Alldeals were verified by searching through SEC filings, Factiva news articles/newswires,and on Lexis-Nexis The sample period was from January 1980 to December 2003

Only completed deals were included in the sample because intentions that do notmaterialize later on cannot be considered as decisions Deals with no match on

Compustat were also deleted from the list This was to ensure availability of adequate

2

The probit estimation procedure is adapted from Gujarati, D N 1998 Basic Econometrics, Chapter 15,

pg 491-493.