Answer (D) is correct . Diversification is sometimes claimed to be an advantage of a combination because it stabilizes earnings and reduces the risks to employees and creditors. Thus, the coinsurance effect applies. If one of the combining firms fails, creditors can be paid from the assets of the other. However, whether shareholders benefit is unclear. One argument supporting the view that diversification by itself does not benefit shareholders is that the decrease in earnings variability increases the value of debt at the expense of equity. Absent synergy, the value of the combined firm is the same as the total of the values of the separate firms. Because the debt increases in value as a result of the decreased risk of default (the coinsurance effect), the value of the equity must therefore decrease if the total value of debt and equity is unchanged.
Answer (A) is incorrect because Systematic risk cannot be diversified.
Answer (B) is incorrect because The debt should be more valuable if the risk of default is lower.
Answer (C) is incorrect because Unsystematic risk is reduced by diversification.
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