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Chapter 7

Corporate Diversification

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall.

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Corporate Diversification Corporate Diversification

The Strategic Management Process


External Analysis Strategic Choice

Mission

Objectives

Strategy Implementation

Competitive Advantage

Internal Analysis

Which Businesses to Enter? Corporate Level Strategy

Vertical Integration
Diversification

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Corporate Diversification Corporate 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
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Corporate Diversification Corporate Diversification

Integration and Diversification


Integration

Backward

Forward

Diversification
Other Businesses Current Businesses Unrelated Other Businesses

No Links

Related

Many Links
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Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall.

Corporate Diversification Corporate 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
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Corporate Diversification Corporate 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
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Corporate Diversification Corporate 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 2012 Pearson Education, Inc. publishing as Prentice Hall.

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Corporate Diversification Corporate 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 2012 Pearson Education, Inc. publishing as Prentice Hall.

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Corporate Diversification Corporate 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

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Corporate Diversification Corporate Diversification

Value of Diversification
Business X + Business Y + Business Z

Value

Independent: equity holder could buy shares of each firm

Focal Firm

Business X
Economies Of Scope

Business Y Business Z

Value

Combined: equity holder buys shares in one firm


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Corporate Diversification Corporate Diversification

Economies of Scope
Four Types Operational Financial Anticompetitive Managerialism

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Corporate Diversification Corporate 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
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Corporate Diversification Corporate 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
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Corporate Diversification Corporate 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

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Corporate Diversification Corporate 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

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Corporate Diversification Corporate 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
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Corporate Diversification Corporate 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
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Corporate Diversification Corporate 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
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Corporate Diversification Corporate 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
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Corporate Diversification Corporate Diversification

Imitability of Diversification
Duplication of Economies of Scope
Less Costly-to-Duplicate Costly-to-Duplicate Core Competencies Internal Capital Allocation Multipoint Competition Exploiting Market Power (tacit/intangible)

Employee Compensation
Tax Advantages Risk Reduction Shared Activities* (codified/tangible)

*may be costly depending on relationships


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Corporate Diversification Corporate 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
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Corporate Diversification Corporate 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 2012 Pearson Education, Inc. publishing as Prentice Hall.

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Corporate Diversification Corporate 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 2012 Pearson Education, Inc. publishing as Prentice Hall.

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Corporate Diversification Corporate Diversification

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall


Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall.

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