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TRANSCRIPT
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What is Diversification?
A collection of businesses under onecorporate umbrella
Prannoy K.K
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Introduction
Why Firms Diversify
To grow
To more fully utilize existing resources and capabilities.
To escape from undesirable or unattractive industry
environments.
To make use of surplus cash flows.
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Introduction (cont.)
Horizontal or related diversification
Strategy of adding related or similar product/service lines to
existing core business, either through acquisition of
competitors or through internal development of new
products/services.
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Introduction (cont.)
Horizontal or related diversification
Advantages
Opportunities to achieve economies of scale and scope.
Opportunities to expand product offerings or expand into
new geographical areas.
Disadvantages of related diversification
Complexity and difficulty of coordinating different but
related businesses.
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Introduction (cont.)
Conglomerate or unrelated diversification
Firms pursue this strategy for several reasons:
Continue to grow after a core business has matured orstarted to decline.
To reduce cyclical fluctuations in sales revenues and cash
flows.
Problems with conglomerate or unrelated diversification:
Managers often lack expertise or knowledge about their
firms businesses.
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Levels and Types of Diversification
Low Levels of Diversification
Single Business
> 95% of business from a single
business unit
Dominant Business
Between 70 and 95% of business
from a single business unit
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Related Constrained
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Related Linked (Mixed)
< 70% of revenues from dominantbusiness, and only limited links
exist
Moderate to High Levels of Diversification
Levels and Types of Diversification
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Unrelated
< 70% of revenue comes from thedominant business, and there are
no common links between
businesses
Very High Levels of Diversification
Levels and Types of Diversification
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RATE OF PROFIT > COST OF CAPITAL
INDUSTRY
ATTRACTIVENESS
COMPETITIVE
ADVANTAGE
Superior profit derives from two sources:
Diversification decisions involve these same two issues:
How attractive is the sector to be entered?
Can the firm achieve a competitive advantage?
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Reasons for DiversificationReasons to Enhance Strategic
Competitiveness
Economies of scope
Market power
Financial economics
Incentives
Resources
Managerial
Motives
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Resources with varying
effects on value creation and
strategic competitiveness Tangible resources
financial resources
physical assets
Intangible resources
tacit knowledge
customer relations
image and reputation
Incentives
Resources
Managerial
Motives
Reasons for Diversification
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Adding Value by DiversificationDiversification most effectively adds value by either of two
mechanisms:
Economies of scope: cost savings attributed to transferring the
capabilities and competencies developed in one business to a new
business
Market power: when a firm is able to sell its products above the
existing competitive level or reduce the costs of its primary and
support activities below the competitive level, or both
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Incentives with Neutral
Effects on Strategic
Competitiveness Anti-trust regulation
Tax laws
Low performance
Uncertain future cash flows
Firm risk reduction
Incentives
Resources
Managerial
Motives
Reasons for Diversification
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Incentives to Diversify
Internal Incentives:
Poor performance may lead some firms to diversify an attempt
to achieve better returns
Firms may diversify to balance uncertain future cash flows
Firms may diversify into different businesses in order to reduce
risk
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Managerial Motives (Value
Reduction)
Diversifying managerialemployment risk
Increasing managerial
compensation
Incentives
Resources
Managerial
Motives
Reasons for Diversification
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Managerial Motives to
Diversify
Managers have motives to diversify
diversification increases size; size is associated with executive
compensation
diversification reduces employment risk
effective governance mechanisms may restrict such motives
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Motives for Diversification
GROWTH --The desire to escape stagnant or declining industriesa powerful motives for diversification (e.g. tobacco,oil, newspapers).
--But, growth satisfies managers not shareholders.
--Growth strategies (esp. by acquisition), tend todestroy shareholder value
RISK --Diversification reduces variance of profit flowsSPREADING --But, doesn't create value for shareholdersthey can
hold diversified portfolios of securities.--Capital Asset Pricing Model shows that diversification
lowers unsystematic risknot systematic risk.
PROFIT --For diversification to create shareholder value, thenbringing together of different businesses undercommon ownership & must somehow increase
their profitability.
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WHEN DOES DIVERSIFICATION
START TO MAKE SENSE?
Strong competitive position,
rapid market growth -- Not a
good time to diversify
Strong competitive position,
slow market growth --
Diversification is top priority
consideration
Weak competitive position,
rapid market growth -- Not a
good time to diversify
Weak competitive position,
slow market growth --
Diversification merits
consideration
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Diversification and Shareholder Value:Porters Three Essential Tests
If diversification is to create shareholder value, it must meetthree tests:
1. The Attractiveness Test: diversification must be directedtowards actual or potentially-attractive industries.
2. The Cost of Entry Test: the cost of entry must not capitalizeall future profits.
3. The Better-Off Test: either the new unit must gaincompetitive advantage from its link with the corporation, orvice-versa.
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Strategies for Diversification
1.Acquire existing firm in targetindustry
2. Start new company internally
3. Form joint venture
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Conclusions
Size alone does not guarantee firms an advantage.
Coordination required to exploit economies of scale
and scope is not without cost.
Size creates additional challenges and difficulties,
including problems of communication and
coordination.
Higher levels of diversification are not incompatible with
high performance -- nor do they necessarily imply that
firms will suffer lower performance levels.
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Conclusions (cont.)
Critical factor in determining success is the level of
management expertise in formulating and implementing
corporate strategy.
More difficult for diversified firms.
Managers of large diversified firms possess a variety of
well-developed mental models that provide them with
powerful understandings of how to manage their firms.
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When to Stop Diversifying
When you achieve acceptable levels of growth and
profitability
Before complexity outstrips management's ability to manage
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Restructuring
A strategy through which a firm changes its set of businesses
or financial structure
Failure of an acquisition strategy often precedes a
restructuring strategy
Restructuring may occur because of changes in the
external or internal environments
Restructuring strategies:
Downsizing
Downscoping
Leveraged buyouts