CONSTRAINED DIVESTITURE AND OWNERSHIP UNBUNDLING
Margarethe Rammerstorfer, Vienna University of Economics and Business Administration, Corporate Finance Group, Heiligenstaedter
Str. 46-48, phone: +43-31336-5995, e-mail: [email protected]
Overview
In recent years, it was often criticized that regulated utilities are still not sufficiently competitive and transparent in pricing. As
a consequence, the European Union decided on several directives concerning the unbundling of vertically integrated
companies. Unbundling in general is similar to divesting a certain corporate division and can be distinguished into unbundling
of accountants, legal unbundling and ownership unbundling. Unbundling of accountants implies different cost accountings and
controlling facilities for each company division whereas under legal unbundling, also management activities throughout the
divisions are separated. Ownership unbundling is the most restrictive form and has recently been highly disputed. This concept
aims to explain, the separation of ownership and control. In the context of regulated utilities, ownership unbundling implies a
sell off of the transmission operators which become independent operators for the operational and commercial grid
management as well as maintenance and financial allocation, afterward. In a first step, I derive variables that exert influence on
the decision to spin off or sell off certain parts of a company. Moreover, I analyze how rational agents in the utility sector
should decide on divestitures, independent from the regulatory background and given the variables derived upfront. Therefore,
the article is organized as follows. Section (2) derives the formal framework for analyzing optimal divestiture decisions, based
on the model implemented by Khan and Mehta (1996). Based on this, the investor’s optimal choice is analyzed in section (3).
Herein, the results are differentiated with respect to the company’s size. Finally, the last section summarizes the findings and
draws together the principal conclusions.
Methods
The first part of the model allows analyzing the firm value of an integrated as well as legal and ownership unbundled company.
For this, the following assumptions have to hold:
1) The considered company consists of at least two divisions.
2) The costs of the company are composed of unique and joint costs.
3) We assume that there exists the possibility of insolvency such that debt bears a certain risk. Hence, bankruptcy related
costs are positive.
4) There exists no inventory carry over, i.e. all ''produced'' units are sold.
f divisions, the value maximization function is therefore, given by:
 f 1

1
max V =  [ Pj (Q j )Q j  C j (Q j )] 
[ S (Q1 ,..., Q f )  R ( D )] (1   )
k a ( D, E )
 j =1 k j

Assuming a firm with
f
 Di  D  [I j (Q j )  D  E ]
j =1
With Q j as quantity produced and sold, k j
(1)
determining the division costs, P j denotes the price for good j and C j the
j . k a stands for the average cost of capital and depends on the firm’s capital structure.
S (Q1 ,..., Q f ) gives the non-financial overhead costs, while R (D ) measures the indirect cost of debt due to bankruptcy
cost for producing product
when D exceeds a certain critical value ( VD ). Thus, the term in [ ] in the first line, gives the operating profit which yields the
net profit after taxes when multiplied with (1   ) . As debt is tax deductible, and following Modigliani and Miller (1959), the
tax shield ( Di 1) has to be added to this. Let I j (Q j ) denote the required investments (maintenance of equipment etc.)
which can also be regarded as opportunity cost of capital, the third term signals the overall financial resource constraint, i. e.
each additional expenditures have to be financed by debt or equity such that these lead to a change in the capital structure. The
1
Herein, i denotes the rate of return on debt which depends on the default probability of the company or division.
term  results from the Kuhn Tucker condition. It follows for equation (1) that the first term in brackets denotes the net
operating revenue for each division, the second term stands for the overhead cost function and the remaining variables build the
financing resource constraint. With respect to this, we are able to maximize shareholder value and decide on the optimal
product mix and optimal level of debt, simultaneously. Therefore, we derive the optimal product mix as:
1 
V
P C j
=   Pj  (Q j )


Q j  k j 
Q j Q j
 1 S 
I j

(2)
(1   )  
=0
 k Q 
Q j
a
j 

P C j

Defining the marginal operating profit for division j with j = 1,... f by MPj = Pj  Q j
and the divisional
Q j Q j
marginal overhead costs as
MS j =
S
which have to be capitalized with the respective rates ( k j and k a ), and, let MI j
Q j
I j
denote the financing costs of marginal investments given by
Q j
, equation (2) can be rewritten as:
1
1
MPj  MS j  MI j = 0
kj
ka
(3)
Equation (3) measures the profitability of the considered company. Values exceeding or equal to zero indicate that the
considered company operates efficiently. Does the resulting value show a negative sign, the company might be better of by
divesting the company division. If equation (3) argues in favor of a divestiture, the owners have to decide about the legal form
of the divested division in a second step. In case of voluntary divestitures, this follows conditionally on the decision to divest.
Hence, the rejection of divesting a company division would stop the analysis at this point. For regulatory purpose, this cannot
be assigned one to one. In this context, the derivation of the optimal legal choice has to be detached from the previous result.
Due to the implementation of unbundling, the regulator forces a company to divest division j, independent from the optimal
choice resulting from equation (3). Then, we focus on the differentiation between spin off or sell off decision which reduces to
a comparison of the capitalization rates for the complete company and the company division. Finally, the model is tested with
respect to European data.
Results
The empirical analysis showed that about 45 % of transmission and 60 % of distribution firms in 2007 should decide in favor of
divesting and hence should appreciate unbundling in general. Moreover, when comparing the decision of legal or ownership
unbundling, the presented analysis argues in favour of separating ownership and control for transmission operators as it will
leave investors better off. However, we cannot completely confirm the rationality of the recent attitude of European companies
from the industry concerned. Only if the return on equity is the crucial decision variable, an argumentation against ownership
unbundling of transmission operators seems to be reasonable.
Conclusions
In recent years, the European Union decided on several directives concerning the unbundling of vertically integrated companies
which can be regarded as involuntary divestitures. In this context, legal unbundling turns out to be equivalent to spin off a
company division. Herein, ownership and control stays in the current shareholders’ hands, while ownership unbundling goes
along with selling off a certain part of a company. With respect to the current discussion and the European companies’
argumentation against ownership unbundling, we analyze how investors would decide on legal or ownership unbundling from a
rational point of view. Therefore, we refer to the model introduced by Khan and Mehta (1996) and derive the capitalization or
more generally, the discount rate as key factor for divestiture decisions. The empirical analysis provided is based on European
data. Herein, we test whether rational agents would decide in favor of unbundling or divesting a company division, detached
from the regulatory framework in reality. With respect to the return on assets, it turns out that about 50 % of tranmsission and
distribution operators should see unbundling (legal and ownership unbundling) in a positive manner. In a second step, the
benefits of ownership unbundling and legal unbundling are distinguished. Due to the return on capital which represents the rate
of return for equity and debt holders, respectively, it can be shown that ownership unbundling leaves the investors better off if
the company to be divested operates in the transmissionor energy distribution sector and earns revenues above 1,000,000 Euro,
i.e. is a medium or large firm. Contrary to this, if the transmission part to be divested is small, investors will be better off by
refusing a separation of ownership and control. For transmission operators, the latter finding is also confirmed by the return on
equity. Overall, we do not find univocal evidence that undermines the current argumentation in Europe. Consequently, the
3
Intelligent Well Technology: Status and Opportunities for Developing Marginal Reserves
SPE
determination of additional factors which influence a shareholder’s attitude and its characterization whether these are rational
and in line with the regulatory constraints is left for further research.
References
Akerlof, G., 1970, “The Market for Lemons: Quality Uncertainty and the Market Mechanism,” Quarterly Journal of
Economics, 84, 759–773.
Arrow, K. J., 1975, “Vertical Integration and communication,” Bell Journal of Economics, 6, 173–183.
Bolle, F., and Y. Breitmoser, 2006, “On the allocative Efficiency of Ownership Unbundling,” Europa University Viadrina
Frankfurt (Oder).
Brunekreeft, G., and E. Ehlers, 2005, “Does Ownership Unbundling of the Distribution Networks Distort the Development of
Distributed Generation?,” Tilec, Tilburg University.
Buedenbender, U., and P. Rosin, 2007, “Pro und Contra Ownership Unbundling in der Energiewirtschaft,”
Energiewirtschaftliche Tagesfragen, 57, 20–31.
Crocker, K. J., 1983, “Vertical Integration and the strategic use of private Information,” Bell Journal of Economics, 14, 236–
248.
Cusatis, P., J. Miles, and J. Woolridge, 1993, “Restructuring through Spinoffs: The Stock Market Evidence,” Journal of
Financial Economics, 33, 293–311.
Haucap, J., 2007, “The Costs and Benefits of Ownership Unbundling,” Intereconomics, 42, 301–305.
Hoeffler, F., and S. Kranz, 2007, “Legal Unbundling can be a Golden Mean between Vertical Integration and Separation,”
Working Paper.
John, T., 1993, “Optimality of Spin-Offs and Allocation of Debt,” Journal of Financial and Quantitative Analysis, 28, 139–
160.
Joskow, P., 2004, “Transmission Policy in the United States,” AEI Brookings Joint Center for Regulatory Studies, Washington
DC.
Joskow, P., and J. Tirole, 2000, “Transmission rights and market power on electric power networks,” RAND Journal of
Economics, 31, 450–487.
Khan, A. Q., and D. R. Mehta, 1996, “Voluntary Divestitures and the Choice between Sell-offs and Spin-offs,” The Financial
Review, 31, 885–912.
Klein, A., 1986, “The Timing of Substance of Divestiture Announcements; Individual, Simultaneous and cumulative Effects,”
Journal of Finance, 41, 685–696.
Miles, J., and J. Rosenfeld, 1983, “The Effect of Spin-off Announcements on Shareholder Wealth,” Journal of Finance, 38,
1597–1606.
Modigliani, F., and H. Miller, 1958, “The Cost of Capital, Corporation Finance and the Theory of Investment,” The American
Economic Review, 48, p. 261.
Mulder, M., V. Shestalova, and G. Zwart, 2007, “Vertical Separation of the Dutch Energy Distribution Industry: An Economic
Assessment of the Political Debate,” Intereconomics, 42, 305–310.
Rosenfeld, J., 1984, “Additional Evidence on the Relation Between Divestiture Announcement and Shareholder Wealth,”
Journal of Finance, 39, 1437–1488.
Steiner, T., 1997, “The Corporate Sell-Off Decision of Diversified Firms,” Journal of Financial Research, 20, 231–241.
Stigler, G. J., 1951, “The division of labor is limited by the extent of the market,” Journal of Political Economy, 59, 185–193.