Real 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 tested and supported time and again are: 1. firms would be deterred from making costly-to-reverse investments under conditions of high uncertainty (Campa, 1993; Guiso and Parigi, 1999; Folta and O’Brien, 2004) and, 2. if investments were to be made under conditions of high uncertainty, staged/sequential investments will be preferred (eg., joint ventures as opposed a complete investment) because they provide flexibility to deal with uncertainty (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, as developed 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, the conditions 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 to test 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 sample period is from1980 to 2004. All kinds of divestments i.e., spin-offs (where equity in a divested 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 the business 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., high uncertainty 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, high uncertainty in a business unit’s environment has a significant negative association with the decision to divest the business unit. Also, an increase in uncertainty accentuates this negative association of uncertainty with the decision to divest whereas a decrease renders uncertainty irrelevant to the decision to divest. Together, these results show that firms’ decisions to divest business units may be driven by option considerations, particularly when the conditions surrounding the divestment are uncertain. This result holds after controlling for all major theoretical explanations in the divestment literature.
It will be expected that the second prediction from the real options theory about flexible 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 this perspective, firms engage in staged divestments to reduce information asymmetry and maximize proceeds from sales (Zingales, 1995). The second essay builds arguments from real options theory and information asymmetry for staged divestments and tests their relative explanatory power.
These hypotheses are tested using a probit model with selection correction. This method takes the two decisions ”the decision to divest and the decision to divest in a staged manner ”together and jointly maximizes the likelihood. Possible selection effects between non-divesting firms that could potentially impact the decision to divest in staged manner are accounted for. The methodology also shows the close connection between the first and second essays. The first essay forms the theoretical basis for the selection equation in the second essay.
Results show that uncertainty is not significant to the decision to engage in staged divestments. This is a very interesting result because it highlights that real options theory may 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 mitigate adverse 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 and Majluf, 1984). Also as shown in essay 1, from a real options perspective, the decision to divest may be driven by options considerations under conditions of high uncertainty. However, information asymmetry may be less relevant to the decision to divest when there is a great deal of uncertainty about the information itself. Therefore, uncertainty and options considerations may dominate information asymmetry concerns, under certain conditions. Current literature does not consider information asymmetry and uncertainty together to explore these relationships.
The third essay brings these two competing theoretical perspectives together and explores the dynamic relationships between information asymmetry and uncertainty. In particular, under conditions of increasing uncertainty, uncertainty is expected to have a dominating effect over information asymmetry. Therefore, changes in the levels of information asymmetry are not expected to change the lack of significance of information asymmetry to the decision to divest. On the other hand, under conditions of decreasing uncertainty, information asymmetry concerns are expected to surface. Therefore, changes in the levels of information asymmetry should matter. More specifically, an increase in information asymmetry is expected to strengthen the negative relationship of information 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 that under 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 options theory in general, and to divestment literature, in particular.