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CHANGE IN PARENT’S COST OF EQUITY CAPITAL AROUND EQUITY CARVE-OUT

Lewis H.K. Tam

DOI: 10.22495/cocv9i1c4art3

Abstract

Equity carve-out transactions typically result in greater disclosure and more analysts following. Does this change in information environment affect the parent firm’s cost of capital? Having a sample of 142 equity carve-out transactions completed between 1982 and 1997, I examine this question by estimating their cost of equity with a residual income model. The results show that the average cost of equity of parent firms declines by about 64 basis points after carve-outs, after controlling for changes in financial leverage and risk-free rate. This decline in the cost of equity is greater for multi-divisional firms. Equity carve-outs that create pure-plays result in a larger decline in the cost of equity. Furthermore, the greater the increase in analyst following, the larger is the decline in the cost of equity around carve-outs. Overall these results imply that reduction in information asymmetry surrounding equity carve-outs is a key reason for the decline in cost of external financing. The major contribution of this paper is to show that it is the decline in the cost of equity, rather than an expected improvement in future earnings, that generates value for parent firms in equity carve-out transactions.

Keywords: Equity Carve-outs, Corporate Restructuring, Residual Income Model, Unlevered Excess Cost of Equity

How to cite this paper: Tam, L. H. K. (2011). Change in parent’s cost of equity capital around equity carve-out. Corporate Ownership & Control, 9(1-4), 441-454. http://dx.doi.org/10.22495/cocv9i1c4art3

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