Firm Relationships and Valuation

Abstract

We propose a model to study firm relationships that endogenously determine the correlation structure of asset cash flows. Forming a relationship makes firms face the following trade-off in their valuations: On the one hand, collaboration generates an additional payoff component with a positive mean. On the other hand, a relationship makes the firms' cash flows more correlated, which lowers the investor's diversification benefit. We use our model to investigate the incentives of firms to form a relationship and to disclose their relationship to the general public. We show that disclosing relationship information can have real consequences on cash flows through affecting firm relationship at both the intensive and the extensive margins.