Corporate Diversification

Corporate Diversification

Chapter 7 Corporate Diversification Copyright 2008 Pearson Prentice Hall. All rights reserved. 7-1 Corporate Corporate Diversification Diversification The Strategic Management Process External Analysis Mission Strategic Choice Objectives

Strategy Implementation Competitive Advantage Which Businesses to Enter? Internal Analysis Corporate Level Strategy Copyright 2008 Pearson Prentice Hall. All rights reserved. Vertical Integration Diversification 7-22 Corporate Corporate Diversification

Diversification Logic of Corporate Level Strategy Corporate level strategy should create value: 1) such that businesses forming the corporate whole are worth more than they would be under independent ownership 2) that equity holders cannot create through portfolio investing Therefore, a corporate level strategy must create synergies economies of scope - diversification Copyright 2008 Pearson Prentice Hall. All rights reserved. 7-33 Corporate Corporate Diversification Diversification Integration and Diversification

C us D is to m er n tri b ut io Fi rm Fo c al

r pl ie Su p R aw M at er ia l s Integration Forward Backward

Diversification Other Businesses No Links Other Businesses Current Businesses Unrelated Copyright 2008 Pearson Prentice Hall. All rights reserved. Related Many Links 7-44 Corporate Corporate Diversification Diversification

Types of Corporate Diversification At a general level Product Diversification: operating in multiple industries Geographic Market Diversification: operating in multiple geographic markets Product-Market Diversification operating in multiple industries in multiple geographic markets Copyright 2008 Pearson Prentice Hall. All rights reserved. 7-55 Corporate Corporate Diversification Diversification Types of Corporate Diversification At a more specific level Limited Diversification single business: > 95% of sales in single business

dominant business: 70% to 95% in single business Related Diversification related-constrained: all businesses related on most dimensions related-linked: some businesses related on some dimensions Unrelated Diversification businesses are not related Copyright 2008 Pearson Prentice Hall. All rights reserved. 7-66 Corporate Corporate Diversification Diversification Product and Geographic Diversification Possibilities: single-business in one geographic area single-business in multiple geographic areas related-constrained in one or multiple geographic areas related-linked in one or multiple geographic areas

unrelated in one or multiple geographic areas Note: relatedness usually refers to products seemingly unrelated products may be related on other dimensions Copyright 2008 Pearson Prentice Hall. All rights reserved. 7-77 Corporate Corporate Diversification Diversification Competitive Advantage If a diversification strategy meets the VRIO criteria Is it Valuable? Is it Rare? Is it costly to Imitate? Is the firm Organized to exploit it? it may create competitive advantage. Copyright 2008 Pearson Prentice Hall. All rights reserved.

7-88 Corporate Corporate Diversification Diversification Value of Diversification Two Criteria 1) There must be some economy of scope 2) The focal firm must have a cost advantage over outside equity holders in exploiting any economies of scope Copyright 2008 Pearson Prentice Hall. All rights reserved. 7-99 Corporate Corporate Diversification Diversification Value of Diversification Business X + Business Y + Business Z

Value Independent: equity holder could buy shares of each firm Focal Firm Economies Of Scope Business X Business Y Value Business Z Combined: equity holder buys shares in one firm Copyright 2008 Pearson Prentice Hall. All rights reserved. 7-10 10 Corporate Corporate Diversification Diversification

Economies of Scope Four Types Operational Financial Anticompetitive Managerialism Copyright 2008 Pearson Prentice Hall. All rights reserved. 7-11 11 Corporate Corporate Diversification Diversification Economies of Scope Operational Economies of Scope Sharing Activities exploiting efficiencies of sharing business activities Example: Frito-Lays Trucking Spreading Core Competencies

exploiting core competencies in other businesses competency must be strategically relevant Example: Orbitz Copyright 2008 Pearson Prentice Hall. All rights reserved. 7-12 12 Corporate Corporate Diversification Diversification Economies of Scope Financial Economies of Scope Internal Capital Market premise: insiders can allocate capital across divisions more efficiently than the external capital market works only if managers have better information may protect proprietary information may suffer from escalating commitment Example: Hanson Trust, PLC Copyright 2008 Pearson Prentice Hall. All rights reserved.

7-13 13 Corporate Corporate Diversification Diversification Economies of Scope Financial Economies of Scope Risk Reduction counter cyclical businesses may provide decreased overall risk however, individual investors can usually do this more efficiently than a firm Example: Snow Skiis & Water Skiis Copyright 2008 Pearson Prentice Hall. All rights reserved. 7-14 14 Corporate Corporate Diversification

Diversification Economies of Scope Financial Economies of Scope Tax Advantages transfer pricing policy allows profits in one division to be offset by losses in another division this is especially true internationally can be used to smooth income Example: Ireland Copyright 2008 Pearson Prentice Hall. All rights reserved. 7-15 15 Corporate Corporate Diversification Diversification Economies of Scope Anticompetitive Economies of Scope Multipoint Competition mutual forbearance

a firm chooses not to compete aggressively in one market to avoid competition in another market Example: American Airlines & Delta: Dallas & Atlanta Market Power using profits from one business to compete in another business using buying power in one business to obtain advantage in another business Copyright 2008 Pearson Prentice Hall. All rights reserved. 7-16 16 Corporate Corporate Diversification Diversification Economies of Scope Managerialism an economy of scope that accrues to managers at the expense of equity holders managers of larger firms receive more compensation (larger scope = more compensation)

therefore, managers have an incentive to acquire other firms and become ever larger even though the incentive is there, it is difficult to know if managerialism is the reason for an acquisition Copyright 2008 Pearson Prentice Hall. All rights reserved. 7-17 17 Corporate Corporate Diversification Diversification Equity Holders and Economies of Scope Most economies of scope cannot be captured by equity holders risk reduction can be captured by equity holders Managers should consider whether corporate diversification will generate economies of scope that equity holders can capture if a corporate diversification move is unlikely to generate valuable economies of scope,

managers should avoid it Copyright 2008 Pearson Prentice Hall. All rights reserved. 7-18 18 Corporate Corporate Diversification Diversification Rareness of Diversification Diversification per se is not rare Underlying economies of scope may be rare relationships that allow an economy of scope to be exploited may be rare an economy of scope may be rare because it is naturally or economically limited a soft drink bottler buys the only source of spring water available a hotel in a resort town creates a large water park, there are only enough customers to support one park Copyright 2008 Pearson Prentice Hall. All rights reserved. 7-19

19 Corporate Corporate Diversification Diversification Imitability of Diversification Duplication of Economies of Scope Less Costly-to-Duplicate Costly-to-Duplicate Employee Compensation Core Competencies Tax Advantages Internal Capital Allocation Risk Reduction Multipoint Competition

Shared Activities* Exploiting Market Power (codified/tangible) (tacit/intangible) *may be costly depending on relationships Copyright 2008 Pearson Prentice Hall. All rights reserved. 7-20 20 Corporate Corporate Diversification Diversification Imitability of Diversification Substitution of Economies of Scope Internal Development start a new business under the corporate whole avoids potential crossfirm integration issues

Strategic Alliances find a partner with the desired complementary assets less costly than acquiring a firm Competitors may use these strategies to arrive at a position of diversification without buying another firm Copyright 2008 Pearson Prentice Hall. All rights reserved. 7-21 21 Corporate Corporate Diversification Diversification International Diversification Three Types of International Risk Cultural/Popular product may not be accepted simply

because of your country of origin Example: Resistance to McDonalds by Frances older generation Financial currency exchange Political nationalization quotas general economic conditions tariffs Example: Asian economic crisis of the 1990s

Example: Bolivia nationalized its petroleum industry in the 70s Copyright 2008 Pearson Prentice Hall. All rights reserved. regulations 7-22 22 Corporate Corporate Diversification Diversification International Diversification Managing International Risks Cultural/Popular avoidance neutral branding (disguising country of origin) Example: Where is Hagen-Dazs from? Financial

currency hedging geographic diversification spreading risk across several countries Copyright 2008 Pearson Prentice Hall. All rights reserved. 7-23 23 Corporate Corporate Diversification Diversification International Diversification Managing International Risks Political find a local partner political neutrality negotiation with governments foreign governments often have an interest in direct investment Example: Case International in Brazil Copyright 2008 Pearson Prentice Hall. All rights reserved. 7-24

24 Corporate Corporate Diversification Diversification Summary Corporate Strategy: In what businesses should the firm operate? an understanding of diversification helps managers answer that question Two Criteria: 1) economies of scope must exist 2) must create value that outside equity holders cannot create on their own Copyright 2008 Pearson Prentice Hall. All rights reserved. 7-25 25 Corporate Corporate Diversification

Diversification Summary Economies of Scope a case of synergycombined activities generate greater value than independent activities may generate competitive advantage if they meet the VRIO criteria Firms should pursue diversification only if careful analysis shows that competitive advantage is likely! Copyright 2008 Pearson Prentice Hall. All rights reserved. 7-26 26

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