CDR japan

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Corporate restructuring system and corporate value in Japan

Hiroshi Onuma

School of Management

Tokyo University of Science

500 Shimokiyoku, Kuki-city, Saitama 346-8512

[email protected]

July 2007

* I appreciate the thoughtful comments by Doug Shackelford, Ed Maydew, and some members attending the free

topics workshop held as part of a national conference of the Tax Accounting Research Association 2006. All errors in

this paper are solely my responsibility.

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Corporate restructuring system and corporate value Abstract This paper addresses two questions related to corporate restructuring. First, do market participants react to corporate divestiture announcements? Second, when managers conceive a restructuring plan, what of divestiture methods do they employ in their corporate restructuring? To answer these questions, I composed a useful event study model to measure abnormal returns and attempted to identify the responses of market participants. Using this model, I found a positive reaction to corporate restructuring announcements from both the acquired firms and the target firms. Moreover, using an ordered logit regression model, I have attempted to elicit from my research sample an affirmative result on the method choice. The results provide weak evidence that managers choice of a restructuring method depends on the consideration of certain assumptions.

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Corporate restructuring system and corporate value

1 Introduction

The purpose of this paper is to investigate whether the law and tax systems for corporate restructuring influence

corporate value in Japan. Further, this paper aims to identify the economic factors that affect the choice of the

divestiture method for restructuring. In this research, I assume that managers maximize shareholder wealth in their

divestiture decisions, taking the decision to divest as given. Moreover, organization restructuring decisions reflect

the indicators of corporate financial data and financial data itself. This assumption is consistent with the outcome of

discussions with investment bankers, consultants, and accountants, who indicate that such important decisions

usually concern various other management decisions.

This paper focuses on the restructuring between groups. On collecting financial data and information from

sample firms that carried out organization restructuring, I became aware of an interesting fact. There are two modes

of corporate restructuring. One is restructuring within corporate groups, and the other is restructuring between

corporate groups, which is the main issue in this paper. I have mainly two reasons for concentrating on the latter type

of corporate restructuring.

First, I have a keen interest in the managerial motive for seeking resources outside the organization. In

general, when the management wishes to carry out a series of corporate reconfigurations, I assume it will attempt to

activate idle resources within the organization. On the other hand, it is natural for the management to contemplate a

fusion between the resources within and outside the organization and pursue operating and financial synergies. This

is my question how I can get through some indication from the corporate financial data when I consider from the

latter view.

Second, I am interested in market participants reactions to divestiture announcements. In particular, when

divisions of a firm combine with the departments of other corporate groups, do market participants perceive this as a

good event or a bad one? If a firm attempts restructuring using the managerial resources of another corporate group,

in general, both groups share the stocks of the newly established company. Therefore, even though the newly

established company is separate from the original corporate groups, a certain capital relationship remains between

the groups. Nonetheless, the information buried in the two corporate groups still spills over into the market when

they implement corporate restructuring. This paper empirically analyzes the information hypothesis that corporate

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restructuring, including divestiture and M&A, enhances value because it mitigates the information asymmetry in the

market about the profitability and operating efficiency of the different divisions of the firms undergoing restructuring.

Consistent with this proposition of the information hypothesis, I find that firms that separate their organizational

divisions have lower abnormal returns than firms that incorporate the divisions into the organization.

This research contributes to the growing body of literature examining divisive corporate restructuring all over

the world; Baldwin and Bhattacharyya (1991), Slovin, et al. (1995), Kaiser and Stouraitis (1995), Lang, et al. (1995),

Parrino (1997), Erickson (1998), Maydew, et al. (1999), Krishnaswami and Subramaniam (1999), Krishnaswami, et

al. (1999), Erickson and Wang (2000), Ayers, Lefanowicz, and Robinson (2000), Weaver (2000), Henning and Shaw

(2000), Henning, Shaw, and Stock (2000), Clubb and Stouraitis (2002), and Scholes, et al. (2005) have investigated

why and how firms divest and how the market in general responds to divestiture decisions.

Krishnaswami and Subramaniam (1999) empirically examine the relationship between information asymmetry

and corporate value in corporations. They analyze the information hypothesis and find that firms that engage in

corporate restructuring have higher levels of information asymmetry than their industry- and size-matched

counterparts and that the information problems decrease significantly after corporate restructuring. In addition, they

endeavor to investigate the market reaction and find that abnormal returns around the dates of corporate

restructuring announcements are positively related to the degree of information asymmetry and that this relation is

more obvious in the case of firms with fewer negative synergies between divisions. Ultimately, firms with higher

growth opportunities and those in need of external capital show a higher propensity to engage in corporate

restructuring.

Maydew, et al. (1999) examine the extent to which taxes influence the choice of the divestiture method, which

could be either tax-free corporate restructuring or a taxable sale. They find that the tax costs are substantial,

averaging 8% of the market value of the divested assets, and that cross-sectional deviations in tax costs have a large

impact on managers choice of a divestiture method. Their results are consistent with two explanations. First,

managers are willing to incur avoidable tax costs to gain earnings and cash flow benefits. Second, managers prefer

the taxable sale option because the acquisition premium on the sale exceeds the avoidable tax cost.

Frank and Harden (2001) investigate corporate restructuring and divisive corporate restructurings in which a

firm makes a subsidiary public. By comparing equity carve-out with corporate restructuring, they examine which

characteristics affect the choice between these alternatives. They find that cash constraints, marginal tax rates,

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subsidiary profitability, and the growth potential of the subsidiarys industry are significant factors associated with

the choice of the divestiture method. Firms that opt for equity carve-out are more likely to be cash constrained and

have lower marginal tax rates. In addition, the subsidiaries of such firms are more likely to belong to higher-growth

industries and are more profitable than corporate restructuring subsidiaries, implying that the market demand for

shares may be factored into the divestiture decision. Further, parent firms are more likely to carve-out subsidiaries in

related industries, suggesting that tangible or intangible synergies with the subsidiary may affect the divestiture

structure.

In this study, I examine 61 cases on corporate restructuring. In particular, this research focuses on the

restructuring between corporate groups. In the market analysis, I found that the market reacts to corporate

restructuring announcements positively, but this response is temporary. Without exception, the initial reactions of

both the acquirer and target firms are positive and significant, but 5 days after the announcement, the result tends

toward insignificance. Next, this paper examines what motivates managers to attempt to restrict their organization

using various methods. Based on an ordered logit regression model, I analyze the methods that managers select and

the factors they focus and rely on. As a result, I find that firms that carry out restructuring between corporate groups

initially intend to establish a new company in cooperation with other firms and seek a different restructuring method.

The paper proceeds as follows. The next section describes the tax aspects of several corporate divestiture methods

exclusive to the Japanese law system. Section 3 develops a hypothesis about market analysis. Section 4 describes the

sample of this research and reports the empirical methodology and result of the market analysis. Then, Section 5

proposes the hypotheses and discusses the results of a logit model used to analyze the relative importance of the

various decision criteria in choosing a divestiture method. Finally, Section 6 provides suggestions for future

research.

2 Structural analysis of corporate restructuring in Japan

2.1 Various types of corporate restructuring schemes in Japans corporate law

The new corporate divestiture system, introduced in 2001, refashioned the old system by classifying corporate

divestitures into four types. Corporate divestiture means that the divesting parent takes over the target organization.

Before proceeding to the research design topics, I will briefly describe the Japanese law system pertaining to

accounting and taxation.

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Company law governs all business practices in Japan. The other laws, such as the Securities and Exchange Law and

corporate tax law, hold a subordinate position to Japanese company law (JCL). JCL was amended to Japanese

commercial law and enacted in 2006. JCL defines corporate divestiture as the separation of business departments; it

does not assume the separation of subsidiaries. The term divestiture is based on the sellers viewpoint. From the

target firms viewpoint, the same event is referred to as a combination in the sense that existing businesses are

combined and transformed into another business.

When the target is an existing company, we refer to this type of divestiture as kyuushuu-bunkatsu, or absorbed

divestiture (AD). On the other hand, when the target is a new company, we refer to this type of divestiture as

shinsetsu-bunkatsu, or newly formed divestiture (NFD). In corporate divestitures, the target firm issues the stocks in

consideration of the transfer of the organization.

When these stocks are allotted to the divesting parent, we refer to this type of divestiture as butteki-bunkatu or

bunshagata-bunkatsu, which is similar to a spin-off or subsidiary sale. When these stocks are allotted to the

shareholders of the divesting parent, we refer to this type of divestiture as jinteki-bunkatu or bunkatsugata-bunkatsu,

which is similar to a split-off or a spin-off.

The JCL classification has only four types of divestitures. The first type is called newly formed asset sold

divestiture (we refer to this as shinsetsu-butteki-bunkatsu). In this type of divestiture, the target issues the stocks as

the proceeds of a transfer of the organization, and these stocks are allotted to the divesting parent. This type of

divestiture is similar to subsidiary sales and asset sales. The second type of divestiture is called newly formed

spin-off divestiture (we refer to this as shinsetu-jinteki-bunkatsu). In this type of divestiture, the target issues stocks

as the proceeds of a transfer of the organization, and these stocks are allotted to the shareholders of the divesting

parent company. This type of divestiture is similar to a spin-off.

The third type of divestiture is called absorbed asset sold divestiture (we refer to this as

kyushu-butteki-bunkatsu). This type of divestiture is actually the same as an asset sale to the other corporation. After

the department or division is sold to another company, the target allots its stocks to the original company as proceeds.

The fourth type of divestiture is called absorbed spin-off divestiture (we refer to this as kyushu-jinteki-bunkatsu).

After the department or division is sold to another company, the target allots its issued stocks to the shareholders of

the original company, that is, the divesting parent, as proceeds.

The entire structure of the new Japanese divestiture system is shown in Figure 1.

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(Insert Figure 1 here.)

There are other types of restructuring pertaining to the creation of a cooperative organization. On this scheme, we

have several types of divestiture. One is cooperative newly formed spin-off divestiture, and the other is cooperative

absorbed divestiture. Cooperative newly formed spin-off divestiture means that two or more firms establish a new

company collaboratively and transfer management resources and risks to this new company.

(Insert Figures 2 and 3 here.)

Among other types of organization restructuring, there are two forms of reorganization: (1) stock transfer and

(2) stock-for-stock merger. Stock transfer is a method of founding a new holding company in which the original

companies transfer their outstanding shares in the securities market. Stock-for-stock merger is another method of

transforming a company into a wholly owned subsidiary.

(Insert Figure 4 here.)

2.2 Overview of the tax system for corporate restructuring

In 2002, we renewed our taxation system pertaining to corporate restructuring. The rules of corporate tax law

governing division divestiture were amended to devise the new system for corporate restructuring, including

tax-qualified divestiture, merger, and so on.

Corporate tax law is applicable only for divestitures resulting in newly formed companies. The thoughts

underlying these rules are different in Japanese corporate law and the US-IRC, which rests on the consolidated

financial accounting perspective. According to corporate tax law in Japan, there are two types of divestiture:

tax-qualified divestiture, or tax-free divestiture, and tax-disqualified divestiture, or taxable divestiture.

Those opting for tax-qualified divestiture need to meet certain requirements (2.12-11, Reg. 4-2.46). I will

briefly introduce these rules. Basically, the divesting parent owns 100% shares of the target firm. However, if the

divesting parent owns over 50% but less than 100% of the targets shares, the parent firm can enjoy the benefit of

tax-disqualified divestiture as long as it satisfies the following conditions.

z The target takes over from the divesting parent the main assets and liabilities that constitute the transferred

business.

z The target takes over 80% of the employees who work for the transferred business.

z The target operates the business that is transferred from the divesting parent.

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In case the divesting parent and target opt for a cooperative newly formed spin-off divestiture, the parent firm can

enjoy the benefit of tax-disqualified divestiture as long as it meets the following conditions:

z The target continues to hold the stocks distributed from the divesting parent on the date of divestiture.

z The target takes over from the divesting parent the main assets and liabilities that constitute the transferred

business.

z The target takes over 80% of the employees who work for the transferred business.

z The target operates the business that is transferred from the divesting parent.

The cost of divestiture can be reduced by satisfying the abovementioned conditions. Therefore, it is presumed

that the new company law and taxation rules for divestiture encourage corporate restructuring.

3 Hypothesis development

According to Krishnaswami and Subramaniam (1999), the potential sources of gains from corporate

restructuring, including spin-offs and M&A, analyzed in these studies may be classified as follows: (i) transfer of

wealth from bondholders to shareholders, (ii) restructuring of incentive contracts, (iii) tax and regulatory advantages,

and (iv)improved focus and elimination of negative synergies. Among these explanations, the improved focus and

elimination of negative synergies hypothesis has received broad empirical support. Therefore, it is relevant to review

the extant literatures and develop my hypothesis for this investigation.

The transfer of wealth hypothesis argues that during corporate restructuring, the assets and liabilities are

restructured in a manner that involves a transfer of wealth from the bondholders and other stakeholders to the

shareholders of the firm. A recent example of wealth transfer through organizational restructuring has been cited in

Parrino (1997). In a case study of the Marriott spin-off, he shows that the restructuring not only reduced the

collateral on Marriott's existing debt but also reduced the bondholders claims on cash flows from the business. This

resulted in a large increase in the stock price and an associated decrease in the value of the firms debt. This research

provides apparent evidence of wealth transfer from bondholders to shareholders.

More generally, the restructuring of the incentive contract hypothesis asserts that the gains from corporate

restructuring arise from unique contracts after the restructuring, which improve the incentives of the different

stakeholders of the firm1. Schipper and Smith (1983) also investigated various regulatory motives for restructuring.

1 Aron (1991) argues that for a large, multiproduct firm, the stock price is a very noisy signal of any one divisional

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They argued that a regulated firm might reorganize a subsidiary in a manner that results in either the parent or the

subsidiary escaping the external constraint of regulation. A firm in the US may be able to restructure an overseas

subsidiary to avoid paying taxes on the income from that division. Although there do exist benefits to individual

firms from such motivations, on average, the authors do not find any evidence to support these hypotheses.

In a study of 78 spin-offs, Seward and Walsh (1996) found that after a spin-off, both the board of directors and

the compensation committees comprise mostly outside directors, suggesting that the implementation of restructuring

helps internal governance and control mechanisms to function efficiently. They also found that the compensation of

the CEO of the extracted subsidiary is typically based on corporate performance. However, they found that the gains

of corporate restructuring are not statistically related to these improvements in contracting efficiency.

Hite and Owers (1983), Schipper and Smith (1983), Daley, et al. (1997), and Desai and Jain (1999) assert that

the gains from corporate restructuring could arise from improvements in the firms focus and the elimination of

negative synergies between the parent and the subsidiary. Daley, et al. (1997) and Desai and Jain (1999) document

that in the year following a corporate restructuring event, the separate divisions that operate in different industries

show a significant improvement in their operating performance2. Hite and Owers (1983) classify firms based on the

reasons given by the firms for their corporate restructuring. They find that the subsample where the motivation was

improvement in focus exhibits the largest abnormal returns in the period from 50 days prior to the announcement to

the completion date of the corporate restructuring. Indirect evidence for the focus improvement motive is also

provided by Allen, et al. (1995), who examine whether the abnormal returns around corporate restructuring

announcement dates are a consequence of the correction of a prior mistake. They show that when corporate

restructuring is preceded by the acquisition of the division, the positive abnormal returns around the corporate

restructuring announcement dates represent the recreation of value that was destroyed at the time of the earlier

acquisition. The extant empirical evidence therefore indicates that the benefits of corporate restructuring arise

predominantly from the separation of diverse units, which improves focus and eliminates negative synergies

between divisions. Cusatis, et al. (1993) note significant long-term abnormal returns following corporate

managers productivity. Generally speaking, separation through corporate restructuring is accepted as the most favorable signal since managerial compensation that is based on the productivity and efficiency of individual divisions enhances managers incentives. 2 In particular, Desai and Jain (1999) use two other methods to identify focus-improving organizational restructurings. They report that the improved operating and financial performance following corporate restructurings is robust to the classification scheme.

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restructurings, but find that these returns are confined to the subsample of firms that are acquired within a three-year

period after the corporate restructuring. The authors suggest that corporate restructurings facilitate takeovers by

isolating specific divisions, which increases their value to the bidders. However, this increase in value may arise

from two distinct sources. It may be due to the elimination of negative synergies between the parent and the

subsidiary. An alternative explanation is that since the two entities are separate after the organizational restructuring,

the bidder can evaluate the separate entities better than before, thereby resulting in the mitigation of the standard

adverse selection problem that arises under information asymmetry.

There are several testable implications of the information hypothesis. First, firms that engage in organizational

restructuring should have higher levels of information asymmetry about their value than other firms. Second, the

abnormal returns at the restructuring announcements should be positive since undervalued firms engage in

organizational restructuring only in equilibrium3. Third, if information asymmetry results in undervaluation, then the

wealth gains from a corporate restructuring event should be positively related to the level of information asymmetry

about the firm. Furthermore, by separating the divisions through a divestiture, the individual divisions operating

costs and efficiencies are revealed to the market. Thus, the information hypothesis not only predicts a positive share

price reaction but also predicts that the level of information asymmetry will decrease for these firms after the

achievement of corporate restructuring. Since firms with different divisions operating within the same industry are

likely to have few negative synergies between divisions, when these firms undertake corporate restructuring, we

expect that information asymmetry is a more important explanation of the shareholder gains from the corporate

restructuring4. It is therefore expected that firms that have more growth options in their investment opportunity set

are liquidity constrained to engage in activities related to organizational restructuring. The consequent reduction in

information asymmetry lowers the financing costs for the firm. Finally, evidence that a corporate restructuring event

is followed by either the parent or the subsidiary raising more external capital than before will be consistent with the

information hypothesis.

4 Data and Empirical results

I identified the sample of firms that carried out corporate restructuring through divestitures, spin-offs, M&A, and

3 Nanda and Narayanan (1998) is a representative research that shows that undervalued firms tend to restructure their organizations. 4 Schipper and Smith (1983) and Berger and Ofek (1995) explain the reason for this.

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so on, from the following sources: (1) stock distributions by firms trading on the first and second sections of TSE

(Tokyo Securities Exchange); (2) restructuring announcements in the business papers, including the Nikkei Daily

Newspaper, the Nikkei Financial Newspaper, and the Nikkei Industry Newspaper; and (3) restructuring

announcements during 20002004.

I collected financial and stock data of firms from the Nikkei Needs Financial Quest database and Eol Esper

provided by Eol Inc., Toyo Keizai Shinpousha kabuka database. Finally, I collected more than 600 samples from

these databases. My research objectives rest mainly on the restructuring between corporate groups. Finally, I

identified 61 cases of corporate restructuring in the initial sample. Table 1 provides summary information about the

main variables for this sample: sales, operating profits, total assets, and market value.

(Insert Table1 here.)

Besides, I can identify the distribution considered with respect to the restructuring method. According to this

exhibit, cooperative newly formed spin-off divestitures, newly formed divestitures, and absorbed divestitures

account for over 90% of my sample during 20002004.

(Insert Table 2 here.)

4.1 Event study methodology

Prior studies find positive abnormal returns around corporate restructuring announcement dates. We confirm these

returns by employing the event study methodology used by Chan-Lau (2002). We estimate a market model over a

280-day period ending 21 days before the corporate restructuring announcement.

In this study, we use the constant-mean return model because of its simplicity and robustness. Implementing the

model requires defining the event of interest and the event window, which is the period over which the prices will be

examined. Here, the event is defined as the date when the firm first announces its restructuring plan. The semi-strong

market efficiency hypothesis implies that the firms stock price will be affected by the announcement. Therefore, the

natural choice for the event window is the day of the announcement. However, based on standard procedures, a

2-day event window covering the announcement date and the subsequent day is chosen. To evaluate whether

information regarding the restructuring plans could have been spilled to the markets prior to the announcements, a

5-day event window covering the day preceding the announcement and the announcement date, a 10-day event

window centered on the announcement date, and a 20-day event window centered on the announcement date are

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analyzed as well.

The abnormal return on the stocks of firm i in period t, it, is defined as

it = Rit i (1)

where Rit is the daily stock return of firm i in period t, and i is the mean daily stock return of firm i for the

280-day period before the first day of the event window. It is presumed that abnormal returns are normally

distributed with mean 0 and variance 2. The cumulative abnormal returns during the event period are given by

=

= 21

,21 ),(t

tttii ARttCAR

(2)

where t1 and t2 are the initial and final dates of the event window. The average cumulative abnormal return is derived

by averaging across all firms in the sample.

=

=N

itii ARN

ttCAR1

,211),(

(3)

The variance of the cumulative abnormal returns for firm i can be expressed as

(4)

where is a vector with 1 in the positions from t1 to t2 and 0 elsewhere. The variance of the average cumulative

abnormal return is then computed as

( )[ ] ( ) =

==N

ii ttN

ttttCARVar1

212

2212

21 ),(1,,

(5)

Since CAR is assumed to be normally distributed with mean 0 and variance 2 (t1, t2), the J1 statistic is defined as

( )( ) )0,1(~,

,

21

221

1 NttttCARJ = (6)

J1 is normally distributed with mean 0 and variance 1.

4.2 Empirical result

Table 3 briefly shows the descriptive statistics of the abnormal returns of the acquirer and target. Table 4

summarizes the abnormal returns over different time intervals around the announcement dates for the sample of

firms that engaged in some type of restructuring, including spin-offs and subsidiary sales. Figure 5 shows the

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variations in the cumulative abnormal returns of the samples of both acquirers and targets during the event period.


Table 4 reveals that both the acquirer and the target have an affirmative indication about the cumulative abnormal

returns during the event windows. I obtained significant cumulative abnormal returns on the stocks of the acquirers

and the targets in the 1- and 2-day event windows, which is consistent with the initial hypothesis. In particular, the

cumulative abnormal returns of the target firms in the 1-, 2-, and 5-day event windows present a significant result on

the statistics. The cumulative abnormal returns of the target firms increase, on average, approximately over 2%

during the period before and after 5 days of the corporate restructuring announcement. These facts imply that a

corporate restructuring announcement might dissolve any information asymmetry between firms and investors.

(Insert Table 4 and Figure 5 here.)

On the other hand, the stock price reactions before and after the announcement lead to the inference that investors

did not assess the restructuring plans of firms as highly impressive in the enhancement of corporate value. It appears

that the longer the event period, the smaller is the reaction of the abnormal returns of acquirers; this is specifically

the case 5 days after the announcement date. Further, when I extend the event period to 10 or more days, it appears

difficult to draw a feasible result from Table 3. From the perspective of an efficient market, the information about

corporate restructuring is gradually incorporated into the stock price while some time lag is available Information on

corporate restructuring spreads rapidly through the securities market via the Web and newspapers. This information

is believed to reflect in the future stock prices of the acquired firms as well as the target firms. However, owing to

market efficiency, this type of information is easily reflected in market price formation, so the research results do not

present a clear picture.

5 Multivariate analysis of divestiture choice

5.1 Logit model of divestiture choice

In this section, I construct an ordered logit model to examine how economic factors, including cash flow, stock

price, tax, leverage, and financial reporting considerations, taken together, influence the probability of choosing a

cooperative organization creation method over other methods, such as a spin-off or absorbed divestiture method.

Our goal is to identify the key factors in the decision. For various benefits, our inferences should be interpreted in the

light of possible correlations between our proxies. In terms of the extent of freedom from parent companies and

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main shareholders, there is a certain order among cooperative newly formed spin-off divestiture (CNF), newly

formed divestiture (NFD), and absorbed divestiture (AD). In this respect, managers can exercise the most discretion

in CNF. On the other hand, it is not necessary to have a considerable amount of cash to establish a company if one

opts for the absorbed divestiture method since shares can be used instead of cash.

It is hypothesized that the structure of corporate restructuring depends in part on the managements desire to retain

control of the business segment. Zingales (1995) suggests that a carve-out should be favored when there are benefits

of control to the parent. For example, maintaining control of a subsidiary in an industry related to the parents line of

business could lead to tangible or intangible operating synergies. Tangible relationships could include joint

development of shared technologies or production processes and joint procurement or distribution systems.

Intangible relationships result from sharing knowledge or capabilities. If the subsidiary is entirely unrelated to the

parent, access to the private information of, or exclusive relationships with, the subsidiary is likely to be of little

value to the parent firm. In support of this proposition, Schipper and Smith (1983) and Hite and Owers (1983) find

that a spin-off of an unrelated industry generates positive abnormal returns. Therefore, firms that can benefit from

controlling the subsidiary are predicted to choose a carve-out, and firms that have no benefits of control are likely to

choose a spin-off. This leads to the first hypothesis:

H1: Ceteris paribus, the probability of choosing a divestiture method is increasing in the value of control of the

subsidiary.

To test this hypothesis, I use total assets as a proxy variable of control of the subsidiary. The reason why I

choose this variable is that the size of a company affects the control of its subsidiary. This total assets variable

(ASSET) is measured as the log of the total assets in the year of the event, as an alternative measure of the entire

companys riskiness in the year of the event.

It is predicted that managers choice of the divestiture method depends on the need for finance. The choice may

be driven by the parent corporations need for cash to fund growth, pay back debt or other liabilities, or for

distribution to investors. The existing literature contains mixed evidence regarding fund constraints as a determinant

of choice of the divestiture method. Alford and Berger (1999) and Maydew, et al. (1999) find that the more cash

constrained a firm is, the greater the influence of cash flow need on the choice of the divestiture method. This leads

to the second hypothesis:

H2: Ceteris paribus, the probability of choosing a divestiture method is an increasing function of the firms need for

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cash.

To test this hypothesis, I use two proxies suggested by Maydew, et al. (1999). The first measure I adopt is free

cash flow (CF). This captures the difference between the firms internal supply of funds and desired investment in

the year prior to the divestiture. It is the difference between the parents operating income before depreciation and

the first difference in the total assets. The second measure is the current ratio (CR), which is used to assess the need

for liquid funds because of cash constraints. These variables are all divided by total assets.

Zingales (1995), Slovin, et al. (1995), and Nanda (1991) argue that overvalued subsidiaries should be sold out

while undervalued ones should be spun-off to incumbents in order to maximize the current shareholder value. Firms

with subsidiaries that are undervalued would rather not dilute their shareholder wealth and distribute the shares to

incumbents. Firms with subsidiaries that are overvalued have the opposite incentives. If the subsidiary belongs to a

growth industry or is outperforming industry peers, its market value is expected to increase due to buyer demand,

and the divestiture method the parent chooses depends on how the subsidiary increases its profit. Hence, it is

anticipated that firms with highly attractive or promising subsidiaries are more likely to divest through newly formed

divestiture than cooperative newly formed divestiture. This generates the fourth hypothesis:

H3: Ceteris paribus, the probability of choosing a divestiture method is an increasing function of the market

attractiveness of the subsidiary.

The potential demand for shares is tested using a growth measure of the divested units industry. PBR is the

ratio of the market price of the shares to the book value per share. This variable is a proxy for a growth measure in

the year of the divestiture. We also use an industry-relative measure of profitability (ROA) as a measure of the firms

market value. ROA is the return on assets in the year of the divestiture. Based on the findings of Smith and Watts

(1992) and Michaely and Shaw (1995), we also include leverage (LEV), measured as long-term debt divided by

total assets in the year of the event.

Based on the above discussion, I construct the following research model, which includes the designated

variables.

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)6()Pr()5()Pr()4()Pr()3()Pr()2()Pr(

)1()Pr(

0654321021

0654321012

0654321023

0654321013

0654321032

0654321031

+++++++=+++++++=+++++++=+++++++=+++++++=+++++++=

ASSETCRPBRROALEVCFyyASSETCRPBRROALEVCFyyASSETCRPBRROALEVCFyyASSETCRPBRROALEVCFyyASSETCRPBRROALEVCFyyASSETCRPBRROALEVCFyy

where yi denotes a parameter of choice for the divestiture method. Thus, Pr(y1/y3), the choice of the divestiture

method, takes the value 1 if newly formed divestiture (NFD) is favored over absorbed divestiture, and 0 otherwise.

Pr(y3/y1) represents the reverse situation. Pr(y2/y3) takes the value 1 if cooperative newly formed divestiture is

chosen against absorbed divestiture, and 0 otherwise. Pr(y3/y2) represents the reverse situation. Pr(y2/y1) takes the

value 1 if cooperative newly formed divestiture is chosen against simple newly formed divestiture, and 0 otherwise.

Pr(y1/y2) represents the reverse situation. CF is the free cash flow, computed by subtracting the investing cash flow

from the operating cash flow. LEV is a leverage ratio that represents the debt to equity ratio. ROA is the parent

firms (acquirers) ROA and PBR is the parent firms price to book ratio. CR is the current ratio and ASSET is the

logarithm of the total assets in the year of the event. However, the dependent variables take multiple nominal values,

so typical regression cannot be used. Therefore, in this research, I test the ordered logit regression and estimate the

result using the maximum likelihood method.

Table 5 shows the descriptive statistics of each variable and the correlation matrix among the variables.


5.2 Empirical result

The use of a multivariate model allows us to assess the relative importance of each of the independent variables

on the choice of the divestiture method. Table 6 shows the empirical result for this research design. Briefly, these

results imply that the choice of cooperative newly formed divestiture holds the key to interpret the entire picture.

Almost all coefficients related to the newly formed divestiture are significant.


To the best of my knowledge, the management initially seems to rely on the choice of cooperative newly

formed divestiture. Further, the coefficients of the variables of corporate leverage and total assets reveal insignificant

results, which indicate that size and risk do not have much influence on the managements corporate divestiture

decision. The coefficients of ROA are negative and statistically significant if the management prefers cooperative

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newly formed divestiture to other divestiture methods. On the other hand, the coefficients of PBR are positive and

statistically significant if the management prefers other divestiture methods over cooperative newly formed

divestiture. This result indicates that regarding cooperative newly formed divestiture, the management appears to

concede that the accomplishment of cooperative newly formed companies is accompanied with the loss of

efficiency; however, if it chooses other divestiture methods, it also seeks to gain the chance of growth through

divisive decision-making.

6 Suggestion

The purpose of this study was to examine divisive corporate restructurings in which a firm makes a subsidiary

public. This paper contributes to the literature on divisive corporate restructurings by expanding the findings of

Michaely and Shaw (1995), Maydew, et al. (1999), and the subsequent literature to include a broader sample of

firms and a richer multivariate model that includes additional variables. This expanded model increases the

knowledge of public divestiture choice by confirming some of the prior results on market reaction to divisive

decisions as well as demonstrating where differences lie between the divestitures of corporate subsidiaries,

especially in Japan.

The characteristics of a sample of 61 firms representing newly formed divestiture, absorbed divestiture, and

cooperative newly formed divestiture exclusive to the Japanese legal system over 20002004 were examined.

Similar to the findings of Maydew, et al. (1999), I found that cash need is associated with the occurrence of a

specified divestiture method. I also found that as a divesting firms cash need increases, the firm is more likely to

divest through newly formed divestiture. This evidence further supports the findings of Allen and McConnell (1998),

which suggest that firms divest by making their subsidiaries public because they are cash constrained. Additionally,

contrary to the findings of Michaely and Shaw (1995), I find no differences in size and leverage across the parent

firms. According to these authors, their findings indicated that parent firms that have difficulty accessing the IPO

market will spin-off a subsidiary rather than carve-out. The results of my study, on the other hand, suggest that the

markets demand for the subsidiary plays a significant role in the choice of the divestiture method, implied from the

evidence about PBR. The results suggest that carve-outs are an increasing function of the growth of the subsidiary

industry and the profitability of the subsidiary. This implies that the asset quality of the divested assets affects the

ability to access the market and the choice of the divestiture method, lending additional support to the findings of

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Slovin, et al. (1995) and Zingales (1995).

The role of consolidation for financial reporting purposes was also considered and may have an impact on the

choice of the divestiture method. In this research, it appears that firms attempting to carry out cooperative

restructuring do not prefer earnings maximization. However, this result is confusing. Therefore, some questions

remain as to whether the significant coefficient of subsidiary profitability can be attributed to a desire to improve the

reported financial results or whether it is a measure of market demand for the subsidiary.

Despite this result, knowledge of divestiture choice provides insights into the source of the value gains

associated with divisive restructuring. The selection of the divestiture method, in light of certain firm characteristics,

may also provide insights into managers information about the subsidiary, reducing the information asymmetries of

investors. Additional knowledge of why firms structure their divestitures in the fashion they do will provide insights

into why firms divest in general, due to the fact that the net benefits of doing so depends on the method used. One

direction for future research would be to examine the method of choice among restructuring groups where the

economic impact of all of the factors may be more complicatedly connected. How these variables interact to

motivate a managers choice of the divestiture method interests me. Clearly, the wide range of post-divestiture

ownership suggests that varying motivations are factored into the decision. Finally, the role regulatory bodies play

in the structure of divestitures in regulated industries could be explored. As mentioned previously, Japanese

industries became gradually deregulated in the field of M&A and divestitures. Such a change of regulations affects

their business practices. Perhaps it would be beneficial to understand the impact of these changes on the corporate

structure.

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Figure 1 Divestiture schemes in Japan

Xshareholders

Company X

DepartmentA

Yshareholders

Company Y

Xshareholders

Company X

A company

Xshareholders

Company X A company

Xshareholders

Company X

Yshareholders

Company Y

DepartmentA

Xshareholders

Company X

Yshareholders

Company Y

DepartmentA

Figure 2 Cooperative newly-formed spin-off divestiture

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Shareholders shareholders

a+a b+b

Shareholders Shareholders

a ba+a


a+a b+b


a bab

Shareholders shareholders

a+a b+b


a ba+a


a+a b+b


a bab

Figure 3 Cooperative absorbed divestiture

shareholders shareholders

a b+b


ba+b+c

shareholders

c+c

shareholders

C


ba+b+c

shareholders

C


a b+b


ba+b+c

shareholders

c+c

shareholders

C


ba+b+c

shareholders

C

Figure 4 Stock transfer and stock for stock merger

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Stock for stock merger Stock transfer

Company A Company P

Company B

Company A

Company B

Company C

Company P

Company C

Including ex-s/h B

New establishment

They were ex-s/h C

Figure 5 Cumulative abnormal returns of acquirers and targets

-0.035

-0.03

-0.025

-0.02

-0.015

-0.01

-0.005

0

0.005

0.01

0.015

0.02

-19

-17

-15

-13

-11 -9 -7 -5 -3 -1 1 3 5 7 9 11 13 15 17 19

acquirertarget

Table 1 Descriptive statistics

mean Std.Dv. Q1 median Q3 (million yen)Sales 1700988 3006821 1322452 350459 85692Operating profit 42259.88 105829.7 51550 10160 1092Total Assets 3208282 7724008 3794923 587545 90427market value 4.98E+11 1.29E+12 3.82E+11 9.98E+09 0

Table 2 Distribution of the number between groups (4/1/1999 ~ 3/31/2004)

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Stock transfer 1 1.6%

Stock for stock merger 3 4.9%

Cooperative newly formed divestiture 16 26.2%

Newly formed divestiture 19 31.1%

Absorbed divestiture 22 36.1%

Total 61 100%

Table 3 Descriptive statistics for abnormal returns of acquirer and target

Average abnormal return during event window

Acquirer Target

Mean 0.000393 0.000564

Standard Deviation 0.003509 0.0059597

3Q 0.002534 0.002318

Median 0.000634 0.00027

1Q 0.00269 0.005214

Number 41 41

Table 4 Cumulative abnormal returns and statistical significance

Acquirer CAR Target CAR

Panel A 1-day event window including the announcement date and the day after

CAR 0.010941 CAR 0.026544

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J1 3.7731 J1 10.77818

p-value 0.000478 *** p-value 0.000 ***

Panel B 2-day event window including the announcement date and the day after

CAR 0.015107 CAR 0.022214

J1 4.266587 J1 5.428928

p-value 0.000104 *** p-value 0.000 ***

Panel C 5-day event window including the announcement date and the day after

CAR 0.006703 CAR 0.02357

J1 1.226316 J1 2.408843

p-value 0.226602 p-value 0.023 ***

Panel D 10-day event window including the announcement date and the day after

CAR 0.00281 CAR 0.016209

J1 0.22104 J1 1.131011

p-value 0.99999 p-value 0.268 ***

Panel E 20-day event window including the announcement date and the day after

CAR 0.016094 CAR 0.02313

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J1 0.674213 J1 0.65714

p-value 0.503703 p-value 1.000

Panel F 2-day event window of the announcement date and the next day

CAR 0.007944 CAR 0.017874

J1 3.368092 J1 5.594269

p-value 0.001582 ** p-value 0.000 ***

Panel G 2-day event window of the announcement date and the day before

CAR 0.008145 CAR 0.019194

J1 5.605766 J1 13.62713

p-value 1.28E-06 *** p-value 0.000 ***

***, **, and * denote significance at the 1%, 5%, and 10% levels (two-sided tests), respectively.

Table 5 Descriptive statistics for a ordered logit regression

Panel A: Descriptive statistics

Variable Mean Std Dev. Q1 Median Q3 N

Current Ratio 91.17253 65.61984 101.44 83.43 50.16 75

Leverage(D/E) 4.496995 7.306063 5.27 2.25 0.93 68

Parent ROA 0.044233 0.055106 0.0566 0.0374 0.0178 81

Parent PBR 3.295117 16.68813 1.83 1.25 0.75 77

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FreeCF/Assets 0.021835 0.043715 0.0472 0.021 0.0027 63

Log Assets 13.28903 2.088894 15.149 13.284 11.412 100

Panel B: Pearson correlation matrix

leverage D/E current ratio parent PBR parent ROA FreeCF/Assets Log Assetsleverage D/E 1 -0.107 -0.0961 -0.3042 0.0126 0.1973current ratio 1 -0.1307 0.2089 0.0165 -0.4381parent PBR 1 -0.0281 -0.0352 -0.0078parent ROA 1 -0.17 -0.2301FreeCF/Assets 1 -0.0474Log Assets 1

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Table 6 Specification and power of the ordered logit regression for identification

Intercept CF LEV ROA PBR CR ASSET R2 2 observatio

(1) NFD/AD 3.84 4.88 0.02 -0.68 -0.40 0.02 -0.39(0.63) (0.17) (0.05) (0.00) (0.25) (2.40) (1.51)

(2) CNF/AD -12.66 31.20 -0.00 -35.86 2.21 0.04 0.43(3.05)* (4.06)** (0.00) (4.83)** (4.85)** (4.54)** (1.09)

(3) ADNFD -3.84 -4.88 -0.40 0.68 0.40 -0.02 0.39(0.63) (0.17) (2.18) (0.00) (0.25) (2.40) (1.51)

(4) ADCNF 12.66 -31.20 0.00 35.86 -2.21 -0.04 -0.43(3.05)* (4.06)** (0.00) (4.83)** (4.85)** (4.54)** (1.09)

(5) CNF/NFD -16.51 26.32 -0.02 -35.18 2.61 0.01 0.82(5.57)** (3.09)* (0.04) (3.84)** (5.66)** (2.36) (3.77)*

(6) NFD/CNF 16.51 -26.32 0.02 35.18 -2.61 -0.01 -0.82(5.57)** (3.09)* (0.04) (3.84)** (5.66)** (2.36) (3.77)*

0.34 30.79*** 41

***, **, * indicate 1%, 5%, and 10% significance, respectively. The number in parenthesis presents a chi-square value.

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