Why Executives Shy Away from Divestitures  621 earnings multiples (whether P/E or enterprise value to EBIT) or earnings per share for the company after the transaction are irrelevant. Because divested units are typically the more mature businesses in a company’s portfolio (with lower earnings multiples), divestitures often lead to increases in earnings mul- tiples and decreases in earnings per share. But this does not indicate anything about value creation. For example, this particular divestment would increase the company’s earnings multiple even when carried out at a price below $450 million (which would clearly destroy value). In addition, changes in earnings per share and the earnings multiple de- pend on how the company decides to use the cash proceeds from the divest- ment: • Holding cash. If the parent holds on to the proceeds, it will dilute its earn- ings per share. The reason is straightforward: the interest rate earned on the cash (1.5 percent, calculated as 2 percent less taxes at 25 percent) is lower than the so-called earnings yield (earnings relative to the value of sales proceeds, 6.8 percent after taxes) of the divested business unit. This is just simple mathematics. However, the equity value increases because the divestiture creates value, and the company’s P/E is higher than before. • Repaying debt. If the parent uses the proceeds to repay debt, earnings per share will still be diluted; the interest rate on the debt, at 4.5 percent after taxes (calculated as 6 percent less taxes at 25 percent), is also lower than the earnings yield of the divested business. Dilution is less than in the scenario where the parent holds the cash, because the interest rate on debt is higher than on cash. Again, the company’s P/E goes up as earnings per share go down, but less so than in the prior scenario. • Buying back shares. If the parent uses the proceeds to buy back shares, earnings per share will be diluted because the earnings yield of the re- maining business (the inverse of the P/E, 6.4 percent) is lower than the earnings yield of the divested business unit (6.8 percent), but the dilu- tion is less than in the other scenarios. The P/E increases but ends up below the P/E in the other two scenarios. In the example shown, the sale proceeds and the amount used for buybacks would have to increase to above $583 million in order for the divestment to become earnings accretive. Even though the divestment causes the size of the company to be smaller (in terms of revenues and market capitalization) and its earnings per share to be lower, shareholders still benefit from this divestment. What matters is that the company generates more value from selling this business than from run- ning it. Shareholders care about value, not size. 622  Divestitures Assessing Potential Value from Divestitures A value-creating approach to divestitures can result in divesting good and bad businesses at any stage of their life cycle. Clearly, divesting a good business is often not an intuitive choice and may be hard for managers. It therefore makes sense to enforce some discipline in active portfolio man- agement—for example, by holding regular, dedicated business exit review meetings, to ensure that the topic remains on the executive agenda, and by assigning units a “date stamp,” or estimated time of exit. This practice has the advantage of obliging executives to evaluate all businesses as their sell- by date approaches, although executives may decide to retain businesses after that date. Other approaches to promote discipline include setting a limit on the number of businesses in the corporate portfolio or aiming for a target balance in acquisitions and divestitures. Such practices help trans- form divestitures from evidence of failure into shrewd strategies for build- ing value. The value created in a divestment for a parent company equals the price received minus the value forgone minus separation costs incurred by the parent: Value Created Price Received Value Forgone Costs of Separation = − − The value forgone equals the stand-alone value of the divested business as run by the current management team, plus any synergies with the rest of the parent’s businesses. It represents the cash flows that the parent company has given up by selling the business. The costs of separation include the costs that the parent incurs to disentangle the business from its other businesses, plus the so-called stranded costs of any assets or activities that have become redundant after the divestment—costs that, as we will see, can often be sub- stantially mitigated by restructuring central and shared services in the parent company. With this further breakdown, we have the following expression for value created: Value Created Price Received Stand-Alone Value of Divested Busin = − ess Lost Synergies Disentanglement Costs Stranded Costs − − − This section discusses these synergies and costs. Also, it examines practical challenges around legal and regulatory issues, as well as pricing and liquidity of the businesses.