The Journal of Financial and Quantitative Analysis, Vol.31, No.1. (Mar.,1996), pp.43-68.
If shareholders own diversified portfolios, and if companies impose externalities on one another, shareholders do not want value maximization to be corporate policy. Instead, shareholders want companies to maximize portfolio values. This occurs when firms internalize between-firms externalities. Any kind of externality, pecuniary or nonpecuniary, vertical or horizontal, suffices. What matters is simply that one company's actions affect another's value. Thus, besides the tradional benefit of risk reduction, portfolio deversification offers additional benefits to shareholders through helping internalize externalities.
This paper documents the extent of diversification and cross-ownership of stocks among companies where these externalities are likely to be large and provides a capital market test of how merger offers vary with the extent of cross-ownership.
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