Date Added: Apr 2009
An affiliate of a business group is an independent legal entity which can raise its own external capital with limited liability while a division of a diversified firm is not. In spite of the difference, prior studies rarely distinguish between them. The authors provide a simple model to compare between business groups and diversified firms focusing on their investment strategies and firm values and considering two kinds of tunneling: within-group tunneling and external tunneling. First, with bankruptcy risk, debt overhang problems are more severe in business groups than in diversified firms due to each affiliate's limited liability. Second, the within-group tunneling of a business group naturally leads to a decrease of the business group value.