What I Teach My Students about the Diversification Discount: A Brief Summary

Students in my Advanced Corporate Finance course address the diversification discount during the segment on mergers and corporate control. My goal is to develop their understanding of both the theoretical and the practical issues surrounding diversifying mergers. First, we discuss the irrelevance of a diversifying merger to firm value under the Modigliani-Miller assumptions. We recall that if shareholders seek diversification of unsystematic risk, they can diversify within their own portfolio directly by buying other stocks, rather than diversifying at the firm level. Discussion then turns to how diversification is different from other motivations for mergers that create value by reducing costs or enhancing revenues.