The Impact of Real Options on Firm Value: A Study on the Value Change Around Diversification

Abstract

The commonly accepted explanation in early studies to diversification discount is that diversification destroys value because of operational inefficiency. Such argument neglects the real options value incorporated in the value measures. It cannot explain why a firm diversifies if diversification is ex ante inefficient either. Our study indicates that diversification activities are strategic decisions that will change growth opportunities, thus the real options, of a firm and will create value impacts that are different from those caused by changes in operational efficiency. We find that diversification activities, especially unrelated diversification activities, carried out by below average performers tend to increase firm value as a result of searching for new growth opportunities. Whereas diversification activities carried out by above average performers tend to decrease firm value as a result of exploiting excess capability. The result indicates that value changes around diversification are more related to the changes in future growth opportunities rather than the changes in operational efficiency. Our evidence shows that diversification is not ex ante inefficient.