4. Diversification

Question 1

Measurements for Successful Diversification

Answer 1

• Objective look at its existing businesses/ value added by the corporation
• Understanding should guide future diversification/ development of skills & activities with which to select further new businesses

Question 2

Motives for Diversification

Answer 2

• Diversification should be in the interest of shareholders not of managers (E.g. for Managerial arrogance/ Empire)
• 1. Growth -> But! cost of entry into different product market
• 2. Risk Spreading -> But! Limited value creation
• 3. Value Creation -> By sharing resources and capabilities across multiple businesses/ EOScale = Decrease average cost of production through different products/ EOScope = Increase in volume of a single product
• 3. Value Creation -> Economies from Internalizing Transactions (Internal capital & labor market transfer)

Question 3

Porters Three Essential Test:

Answer 3

• Attractiveness Test = Attractive industry?
• Cost of Entry Test = Cost of entry must not exhaust all future profits
• Better-Off Test = Potential to generate a competitive advantage (synergy)
• Requires a dynamic view because these tests are interconnected

Question 4

Diversification and Shareholder Value comparison

Answer 4

• Diversified firms not always outperform non-diversified firms
• No significant causality between diversification and profitability
• But! evidence of an inverted-U relationship
• Performance outcomes depend not only on costs/ benefits of diversification but also on its implementation

Question 5

Relatedness and Unrelatedness

Answer 5

• Related diversification outperforms unrelated diversification
• Unrelatedness = No clear opportunity to transfer skills or share important activities (Philip Morris & 7UP)
• Relatedness = Potential for sharing and transferring resources and capabilities between businesses

Question 6

Types of Relatedness

Answer 6

• Operational Relatedness = Synergies from sharing resources across businesses (Brands, Joint R&D)
• Strategic Relatedness = Synergies at corporate level/ Ability to apply common management capabilities & systems & resource allocation processes/ In different businesses

Question 7

Evolution of diversification strategies

Answer 7

• Past two decades strong trend towards firm specialization rather than diversification
• But some Outliers: Chae bol, Keiretsu, Latam Group, Major Business House in India

Question 8

Video Advantages Financial Reasons to diversify

Answer 8

• Reinvest profits into other growth opportunities
• Capitalize on opportunities in related markets
• Reduce volatility by diversifying assets (E.g. unsuccessful movies)
• Reduce overall risk by diversifying assets (E.g. reducing employment)

Question 9

Video Disadvantages Financial Reasons to diversify

Answer 9

• Shareholders can diversify for themselves -> Retained profit must be shared with dividends and they decide where to reinvest
• Internal capital market not necessarily more efficient than public capital markets
• Combining units can compound risks across units by raising costs of volatility and risk of bankruptcy

Question 10

Video Advantages Operational Reasons to diversify

Answer 10

• Exploiting Economies of Scale and Scope
• Transfer/ Leverage assets (Know-how/ Technology between businesses
• Improve coordination among businesses

Question 11

Video Disadvantages Operational Reasons to diversify

Answer 11

• Synergies are hard to realize in practice -> Carefully check feasibility before a merger
• Often synergies can be better achieved through market mechanisms (E.g. outsourcing, alliances, contracts)

Question 12

Video Advantages Strategic Reasons to diversify

Answer 12

• Raise rivals costs
• Multipoint competition = Competitors are in similar markets -> Reduces incentives to fight
• Eliminating competition by encouraging price war among internal BU -> Competitors might have limited access to capital
• Minimizing transaction costs -> Contracts are costly and might be incomplete

Question 13

Video Disadvantages Strategical Reasons to diversify

Answer 13

• May be antitrust violation
• Monopoly position must be maintained in the upstream or downstream activities
• Complexity makes such tacit collusion difficult and when price wars break out they tend to be severe
• Assumes that trust is difficult to achieve in market due to opportunistic behavior of players