The Conglomerate Discount: A New Explanation Based on Credit Risk

We present a simple new explanation for the diversiflcation discount in the valua- tion of flrms. We demonstrate that, ceteris paribus, limited liability of equity holders is su-cient to explain a diversiflcation discount. To derive this result, we use a credit risk model based on the value of the flrm's assets. We show that a conglomerate can be regarded as an option on a portfolio of assets. By splitting up the conglomerate, the investor receives a portfolio of options on assets. The conglomerate discount arises because the value of a portfolio of options is always equal to or higher than the value of an option on a portfolio. The magnitude of the conglomerate discount depends on the number of business units and their correlation, as well as their volatility, among other factors.