Review of Quantitative Finance and Accounting, 20: 35–47, 2003
2003 Kluwer Academic Publishers. Manufactured in The Netherlands.
Using Spinoffs to Reduce Capital Mis-Allocations
MAZHAR A. SIDDIQI
Associate Professor of Finance
DEZIE L. WARGANEGARA
University of North Texas, College of Business Administration, P.O. Box 305339, Denton, TX 76203-5339
Abstract. In this paper, we try to show that mis-allocation of capital in a conglomerate can lead to spinoffs. This
mis-allocation arises when internal cash is not allocated efﬁciently between divisions with differences in growth
opportunities. We show that differences in growth opportunities can predict subsequent spinoffs. We also show
that differences in growth opportunities are better predictors of spinoffs than either the SIC codes that are used in
the corporate focus explanation of spinoffs, or the usual estimates of free cash ﬂow as applied to the conglomerate.
Keywords: capital mis-allocation, cash ﬂow
Conglomerates, unlike single division ﬁrms, have an internal capital market. Cash from
low-growth divisions can be used to ﬁnance high-growth divisions. This provides savings
from reduced transaction costs, and from reduced costs of asymmetric information in the
external capital market. However, this internal capital market, freed from external market
disciplines, may cause capital to be mis-allocated. Capital is mis-allocated if excess cash
from low-growth divisions is kept within the low-growth ﬁrms, or if the little cash that is
generated by the high-growth division is also invested in the low-growth ﬁrm. This may
or may not be an agency problem. Mis-allocation is possible whenever the ﬁrm relies on
internal capital. However, it does not necessarily imply that management is acting against
the interests of shareholders. Stock price is still maximized as long as the savings in trans-
action costs and asymmetric information outweigh the losses from capital mis-allocation.
In this case, other things being equal, the ﬁrm continues as a conglomerate. However if
the costs of mis-allocation exceed the beneﬁts of lower transaction costs and reduced in-
formation asymmetries, the ﬁrm will increase value by a spinoff of one or more of its
We examine non-taxable spinoffs between the years 1980 and 1996. After an appropriate
screening process, that is explained in Section III, we are left with a sample of 117 spinoffs.
This paper’s primary contribution is to show that the evidence supports this capital mis-
allocation hypothesis as an explanation for spinoffs. We also ﬁnd evidence suggesting that
it is, at least in part, an agency problem.