DP8105 Mergers, Diversification and Financial Intermediation

Author(s): Flavio Toxvaerd
Publication Date: November 2010
Keyword(s): Capital tightening, Diversification, Diversification discount, Financial intermediation, Merger waves, Mergers
JEL(s): G34, L16
Programme Areas: Industrial Organization
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=8105

This work presents an equilibrium model of diversification through merger formation. Due to moral hazard problems, poorly capitalized firms are credit rationed and may seek to alleviate the incentive problem (and thereby raise external funds) by either merging, employing a monitor or a combination of the two. Within this setting, the effects on merger activity of different kinds of capital tightening are studied. In particular, credit crunches, collateral squeezes and savings squeezes are analyzed. The main results are that diversifying merger activity increases during times of economic expansion and is positively related to aggregate economic activity, business incorporations and easing of access to credit (both interest and non-interest terms of credit). Furthermore, the model offers a rationale for diversification that is immune to the diversification neutrality result and furthermore, explains why diversified companies trade at a discount relative to their non-diversified counterparts.