BUSI 4940 Chapter 6 (Textbook)

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-Buying and then restructuring service-based assets so they can be profitably sold in the external market is also difficult. Thus, for both high-technology firms and service-based companies, relatively few tangible assets can be restructured to create value and sell profitably -It is difficult to restructure intangible assets such as human capital and effective relationships that have evolved over time between buyers (customers) and sellers (firm personnel). Ideally, executives will follow a strategy of buying businesses when prices are lower, such as in the midst of a recession, and selling them at late stages in an expansion

Reasons for Diversification: Value-Reducing Diversification

-Diversifying managerial employment risk -Increasing managerial compensation

an effective corporate-level strategy creates, across all of a firm's businesses,

-aggregate returns that exceed what those returns would be without the strategy -contributes to the firm's strategic competitiveness and its ability to earn above-average returns

Vertical integration downsides

-an outside supplier may produce the product at a lower cost, so internal transactions from vertical integration may be expensive and reduce profitability relative to competitors -can require substantial investments in specific technologies, and it may reduce the firm's flexibility, especially when technology changes quickly. -changes in demand create capacity balance and coordination problems

Efficient internal capital allocations

-can lead to financial economies. -reduce risk among the firm's businesses

what are the two types of strategies that firms form?

-corporate-level (company-wide) -business-level (competitive)

creating economies of scope by using both operational and corporate relatedness

-difficult for competitors to understand and learn how to imitate -if the cost of realizing both types of relatedness is not offset by the benefits created, the result is diseconomies because the cost of organization and incentive structure is very expensive

facilitating the transfer of corporate-level core competencies

-moving key people into new management positions. However, the manager of an older business may be reluctant to transfer key people who have accumulated knowledge and experience critical to the business's success. Thus, managers with the ability to facilitate the transfer of a core competence may come at a premium, or the key people involved may not want to transfer. -Additionally, the top-level managers from the transferring business may not want the competencies transferred to a new business to fulfill the firm's diversification objectives.* Research suggests that the nature of the top management team can influence the success of the knowledge and skill transfer process.* -Research also suggests too much dependence on outsourcing can lower the usefulness of core competencies, thereby reducing their useful transferability to other business units in the diversified firm

Successful diversification is expected to

-reduce variability in the firm's profitability as earnings are generated from different businesses -can also provide firms with the flexibility to shift their investments to markets where the greatest returns are possible rather than being dependent on only one or a few markets.

An unrelated diversification strategy can create value through

-two types of financial economies -types: Efficient internal capital allocations & the restructuring of acquired assets

economies of scope

cost savings a firm creates by successfully sharing resources and capabilities or transferring one or more corporate-level core competencies that were developed in one of its businesses to another of its businesses

firms with internal capital markets can have at least two informational advantages

1. information provided to capital markets through annual reports and other sources emphasizes positive prospects and outcomes. External sources of capital have a limited ability to understand the operational dynamics within large organizations. Even external shareholders who have access to information are unlikely to receive full and complete disclosure 2. although a firm must disseminate information, that information also becomes simultaneously available to the firm's current and potential competitors. Competitors might attempt to duplicate a firm's value-creating strategy with insights gained by studying such information. Thus, the ability to efficiently allocate capital through an internal market helps the firm protect the competitive advantages it develops while using its corporate-level strategy as well as its various business-unit-level strategies

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The tax effects of diversification stem not only from corporate tax changes, but also from individual tax rates. Some companies (especially mature ones) generate more cash from their operations than they can reinvest profitably. Some argue that free cash flows (liquid financial assets for which investments in current businesses are no longer economically viable) should be redistributed to shareholders as dividends.* However, in the 1960s and 1970s, dividends were taxed more heavily than were capital gains. As a result, before 1980, shareholders preferred that firms use free cash flows to buy and build companies in high-performance industries. If the firm's stock value appreciated over the long term, shareholders might receive a better return on those funds than if the funds had been redistributed as dividends because returns from stock sales would be taxed more lightly than would dividends.

summary 5

Transferring core competencies is often associated with related linked (or mixed related and unrelated) diversification, although firms pursuing both sharing activities and transferring core competencies can also use the related linked strategy.

Financial economies

are cost savings realized through improved allocations of financial resources based on investments inside or outside the firm.

This threat (synergy produces joint interdependence among businesses) may force two basic decisions.

1. the firm may reduce its level of technological change by operating in environments that are more certain. This behavior may make the firm risk averse and thus uninterested in pursuing new product lines that have potential but are not proven 2. the firm may constrain its level of activity sharing and forgo potential benefits of synergy -Either or both decisions may lead to further diversification.* Operating in environments that are more certain will likely lead to related diversification into industries that lack potential,* while constraining the level of activity sharing may produce additional, but unrelated, diversification, where the firm lacks expertise. Research suggests that a firm using a related diversification strategy is more careful in bidding for new businesses, whereas a firm pursuing an unrelated diversification strategy may be more likely to overbid because it is less likely to have full information about the firm it wants to acquire

even when incentives to diversify exist, a firm must have the types and levels of resources and capabilities needed to successfully use a corporate-level diversification strategy.

Although both tangible and intangible resources facilitate diversification, they vary in their ability to create value. Indeed, the degree to which resources are valuable, rare, difficult to imitate, and nonsubstitutable influences a firm's ability to create value through diversification

Synergy

exists when the value created by business units working together exceeds the value that those same units create working independently.

Because firms incur development and monitoring costs when diversifying,

the ideal portfolio of businesses balances diversification's costs and benefits.

Firms seeking to create value through corporate relatedness use

the related linked diversification strategy

how is value created using a corporate-level diversification strategy?

when the strategy allows a company's businesses to increase revenues or reduce costs while implementing their business-level strategies—either through related diversification or through unrelated diversification

related diversification

-A firm is related through its diversification when its businesses share several links. -For example, businesses may share product markets (goods or services), technologies, or distribution channels. The more links among businesses, the more "constrained" is the level of diversification

unrelated diversification strategy

-A highly diversified firm that has no relationships between its businesses -Commonly, firms using this strategy are called conglomerates

Reasons for Diversification: Value-Neutral Diversification

-Antitrust regulation -Tax laws -Low performance -Uncertain future cash flows -Risk reduction for firm -Tangible resources -Intangible resources -a desire to match and thereby neutralize a competitor's market power

uncertain future cash flows & diversification

-As a firm's product line matures or is threatened, diversification may be an important defensive strategy.* Research also suggests that during a financial downturn, diversification improves firm performance because external capital markets are costly and internal resource allocation become more important -Diversifying into other product markets or into other businesses can reduce the uncertainty about a firm's future cash flows

Synergy and Firm Risk Reduction

-Diversified firms pursuing economies of scope often have investments that are too inflexible as they try to realize synergy among business units. As a result, a number of problems may arise -as a firm increases its relatedness among business units, it also increases its risk of corporate failure because synergy produces joint interdependence among businesses that constrains the firm's flexibility to respond.* -This threat may force two basic decisions.

the unrelated diversification strategy has low operational relatedness and low corporate relatedness. How does it create value?

-Financial economies, rather than either operational or corporate relatedness, are the source of value creation

Low levels of Diversification (Single Business & Dominant Business)

-Firms that focus on one or very few businesses and markets can earn positive returns, because they develop capabilities useful for these markets and can provide superior service to their customers. -there are fewer challenges in managing one or a very small set of businesses, allowing them to gain economies of scale and efficiently use their resources

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-Government antitrust policies and tax laws provided incentives for U.S. firms to diversify in the 1960s and 1970s.* Antitrust laws prohibiting mergers that created increased market power (via either vertical or horizontal integration) were stringently enforced during that period. Merger activity that produced conglomerate diversification was encouraged primarily by the Celler-Kefauver Antimerger Act (1950), which discouraged horizontal and vertical mergers. As a result, many of the mergers during the 1960s and 1970s were "conglomerate" in character, involving companies pursuing different lines of business. Between 1973 and 1977, 79.1 percent of all mergers were conglomerate in nature

Moderate to High Levels of Diversification - Types

-Related Constrained: Less than 70% of revenue comes from the dominant business, and all businesses share product, technological, and distribution linkages -Related Linked/Mixed Related and Unrelated: Less than 70% of revenue comes from the dominant business. and there are only limited links between businesses

Low levels of Diversification - Types

-Single Business: 95% or more of revenue comes from a single business -Dominant Business: Between 70 and 95% of revenue comes from a single business

unrelated diversification strategy-developed vs emerging economies

-The Achilles' heel for firms using the unrelated diversification strategy in a developed economy is that competitors can imitate financial economies more easily than they can replicate the value gained from the economies of scope developed through operational relatedness and corporate relatedness. -This issue is less of a problem in emerging economies, in which the absence of a "soft infrastructure" (including effective financial intermediaries, sound regulations, and contract laws) supports and encourages use of the unrelated diversification strategy

Very High Levels of Diversification - Types

-Unrelated: Less than 70% of revenue comes from the dominant business, and there are no common links between businesses

why do firms use corporate-level strategies?

-a means to grow revenues and profits -pursue defensive or offensive strategies that realize growth but have different strategic intents -pursue market development by entering different geographic markets -acquire competitors (horizontal integration) or buy a supplier or customer (vertical integration)

Product diversification

-a primary form of corporate-level strategies -concerns the scope of the markets and industries in which the firm competes as well as "how managers buy, create, and sell different businesses to match skills and strengths with opportunities presented to the firm.

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-firms can create more value by effectively using diversification strategies. However, diversification must be kept in check by corporate governance -Appropriate strategy implementation tools, such as organizational structures, are also important for the strategies to be successful

related linked diversification strategy/mixed related and unrelated firm

-share fewer resources and assets between their businesses, concentrating instead on transferring knowledge and core competencies between the businesses. - companies constantly adjust the mix in their portfolio of businesses as well as make decisions about how to manage these businesses

firms seek to create value from economies of scope through two basic kinds of operational economies:

-sharing activities (operational relatedness) -transferring corporate-level core competencies (corporate relatedness)

what are corporate-level strategies?

-strategies firms use to diversify their operations from a single business competing in a single market into several product markets—most commonly, into several businesses -specifies actions a firm takes to gain a competitive advantage by selecting and managing a group of different businesses competing in different product markets -help companies to select new strategic positions—positions that are expected to increase the firm's value

to create economies of scope,

-tangible resources such as plant and equipment or other business-unit physical assets often must be shared. -Less tangible resources such as manufacturing know-how and technological capabilities can also be shared. -However, know-how transferred between separate activities with no physical or tangible resource involved is a transfer of a corporate-level core competence, not an operational sharing of activities

in an internal capital market

-the corporate headquarters office can fine-tune its corrections, such as choosing to adjust business unit managerial incentives or encouraging strategic changes in one of the firm's businesses.* Thus, capital can be allocated according to more specific criteria than is possible with external market allocations. -Because it has less accurate information, the external capital market may fail to allocate resources adequately to high-potential investments. -The corporate headquarters office of a diversified company can more effectively perform such tasks as disciplining underperforming management teams through resource allocations

it is a related constrained diversification strategy when

-the links between the diversified firm's businesses are rather direct—meaning they use similar sourcing, throughput, and outbound processes -a firm shares resources and activities across its businesses. -allow similarities in production processes and main equipment parts, allowing a transfer of knowledge across these businesses

Activity sharing is also risky because

-ties among a firm's businesses create links between outcomes -activity sharing requires careful coordination between the businesses involved. The coordination challenges must be managed effectively for the appropriate sharing of activities -other research discovered that firms with closely related businesses have lower risk. These results suggest that gaining economies of scope by sharing activities across a firm's businesses may be important in reducing risk and in creating value

Reasons for Diversification: Value-Creating Diversification

1. Economies of scope (related diversification) -Sharing activities -Transferring core competencies 2. Market power (related diversification) -Blocking competitors through multipoint competition -Vertical integration 3. Financial economies (unrelated diversification) -Efficient internal capital allocation -Business restructuring

Value-Creating Diversification Strategies: Operational and Corporate Relatedness (Square Chart)

1. Unrelated Diversification -Low Operational Relatedness - Low Corporate Relatedness 2.Related Constrained Diversification - High Operational Relatedness - Low Corporate Relatedness 3. Related Linked Diversification - Low Operational Relatedness - High Corporate Relatedness 4. Both Operational and Corporate Relatedness -High Operational Relatedness -High Corporate Relatedness

Corporate-level strategy is concerned with two key issues:

1. in what product markets and businesses the firm should compete 2. how corporate headquarters should manage those businesses

sources of value creation using the related linked diversification strategy

1. the expense of developing a core competence has already been incurred in one of the firm's businesses, transferring this competence to a second business eliminates the need for that business to allocate resources to develop it 2. Resource Intangibility: Intangible resources are difficult for competitors to understand and imitate. Because of this difficulty, the unit receiving a transferred corporate-level competence often gains an immediate competitive advantage over its rivals

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Under the 1986 Tax Reform Act, however, the top individual ordinary income tax rate was reduced from 50 to 28 percent, and the special capital gains tax was changed to treat capital gains as ordinary income. These changes created an incentive for shareholders to stop encouraging firms to retain funds for purposes of diversification. These tax law changes also influenced an increase in divestitures of unrelated business units after 1984. Thus, while individual tax rates for capital gains and dividends created a shareholder incentive to increase diversification before 1986, they encouraged lower diversification after 1986, unless the diversification was funded by tax-deductible debt. Yet, there have been changes in the maximum individual tax rates since the 1980s. The top individual tax rate has varied from 31 percent in 1992 to 39.6 percent in 2017. There have also been some changes in the capital gains tax rates.

Vertical integration exists when

a company produces its own inputs (backward integration) or owns its own source of output distribution (forward integration).`

Market power exists when

a firm is able to sell its products above the existing competitive level or to reduce the costs of its primary and support activities below the competitive level, or both.

governance mechanisms

a firm's governance mechanisms may not be strong, allowing executives to diversify the firm to the point that it fails to earn even average returns.* The loss of adequate internal governance may result in relatively poor performance, thereby triggering a threat of takeover. Although takeovers may improve efficiency by replacing ineffective managerial teams, managers may avoid takeovers through defensive tactics, such as "poison pills," or may reduce their own exposure with "golden parachute" agreements.* Therefore, an external governance threat, although restraining managers, does not flawlessly control managerial motives for diversification.

Vertically integrated firms

are better able to improve product quality and improve or create new technologies than specialized firms because they have access to more information and knowledge that are complementary.

Incentives to diversify come from both the external environment and a firm's internal environment. External incentives include antitrust regulations and tax laws. Internal incentives include low performance, uncertain future cash flows, the pursuit of synergy, and reduction of risk for the firm.

both the external environment and a firm's internal environment. -External incentives include antitrust regulations and tax laws. -Internal incentives include low performance, uncertain future cash flows, the pursuit of synergy, and reduction of risk for the firm.

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Corporate tax laws also affect diversification. Acquisitions typically increase a firm's depreciable asset allowances. Increased depreciation (a non-cash-flow expense) produces lower taxable income, thereby providing an additional incentive for acquisitions. At one time, acquisitions were an attractive means for securing tax benefits, but changes recommended by the Financial Accounting Standards Board (FASB) eliminated the "pooling of interests" method to account for the acquired firm's assets. It also eliminated the write-off for research and development in process, and thus reduced some of the incentives to make acquisitions, especially acquisitions in related high-technology industries -Thus, regulatory changes such as the ones we have described create incentives or disincentives for diversification

summary3

Sharing activities usually involves sharing tangible resources between businesses. Examples include transferring core competencies developed in one business to another business, and transferring competencies between the corporate headquarters office and a business unit.

returns and diversification

Some research shows that low returns are related to greater levels of diversification.* If high performance eliminates the need for greater diversification, then low performance may provide an incentive for diversification

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Sometimes, however, the benefits expected from using resources to diversify the firm for either value-creating or value-neutral reasons are not gained. Research suggests that picking the right target firm partner is critical to acquisition success

summary1

The primary reason a firm uses a corporate-level strategy to become more diversified is to create additional value. Using a single- or dominant-business corporate-level strategy may be preferable to seeking a more diversified strategy, unless a corporation can develop economies of scope or financial economies between businesses, or unless it can obtain market power through additional levels of diversification. Economies of scope and market power are the main sources of value creation when the firm uses a corporate-level strategy to achieve moderate to high levels of diversification.

summary2

The related diversification corporate-level strategy helps the firm create value by sharing activities or transferring competencies between different businesses in the company's portfolio.

operational relatedness

opportunities to share operational activities between businesses

unrelated diversification

refers to the absence of direct links between businesses.

Firms can create operational relatedness by

sharing either a primary activity (e.g., inventory delivery systems) or a support activity (e.g., purchasing practices

related diversification

signifies a moderate to high level of diversification for the firm

a corporate-level strategy's value is ultimately determined by

the degree to which "the businesses in the portfolio are worth more under the management of the company than they would be under any other ownership

the restructuring of acquired assets

the diversified firm buys another company, restructures that company's assets in ways that allow it to operate more profitably, and then sells the company for a profit in the external market.

Through vertical integration, market power is gained as

the firm develops the ability to save on its operations, avoid sourcing and market costs, improve product quality, possibly protect its technology from imitation by rivals, and potentially exploit underlying capabilities in the marketplace

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the level of diversification with the greatest potential positive effect on performance is based partly on the effects of the interaction of resources, managerial motives, and incentives on the adoption of particular diversification strategies. As indicated earlier, the greater the incentives and the more flexible the resources, the higher the level of expected diversification. Financial resources (the most flexible) should have a stronger relationship to the extent of diversification than either tangible or intangible resources. Tangible resources (the most inflexible) are useful primarily for related diversification.

the related constrained strategy

the sharing of resources

the related linked strategy

the transferring of core competencies across the firm's different businesses

what are operational relatedness and corporate relatedness?

two diversification strategies that can create value

Multipoint competition exists when

two or more diversified firms simultaneously compete in the same product areas or geographical markets

Some firms using a related diversification strategy engage in

vertical integration to gain market power.

summary 7

Diversification is sometimes pursued for value-neutral reasons. Incentives from tax and antitrust government policies, low performance, or uncertainties about future cash flow are examples of value-neutral reasons that firms choose to become more diversified.

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Diversification provides additional benefits to top-level managers that shareholders do not enjoy. Research evidence shows that diversification and firm size are highly correlated, and as firm size increases, so does executive compensation and social status.* Because large firms are complex, difficult-to-manage organizations, top-level managers commonly receive substantial levels of compensation to lead them, but the amounts vary across countries.* Greater levels of diversification can increase a firm's complexity, resulting in still more compensation for executives to lead an increasingly diversified organization. Governance mechanisms, such as the board of directors, monitoring by owners, executive compensation practices, and the market for corporate control, may limit managerial tendencies to over diversify

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During the 1980s, antitrust enforcement lessened, resulting in more and larger horizontal mergers (acquisitions of target firms in the same line of business, such as a merger between two oil companies).* In addition, investment bankers became more open to the kinds of mergers facilitated by regulation changes; as a consequence, takeovers increased to unprecedented numbers.* The conglomerates, or highly diversified firms, of the 1960s and 1970s became more "focused" in the 1980s and early 1990s as merger constraints were relaxed and restructuring was implemented.

summary 6

Efficiently allocating resources or restructuring a target firm's assets and placing them under rigorous financial controls are two ways to accomplish successful unrelated diversification. Firms using the unrelated diversification strategy focus on creating financial economies to generate value.

Tangible Resources & diversification

Excess capacity of other tangible resources, such as a sales force, can be used to diversify more easily. Again, excess capacity in a sales force is more effective with related diversification because it may be utilized to sell products in similar markets (e.g., same customers). The sales force would be more knowledgeable about related product characteristics, customers, and distribution channels.* Tangible resources may create resource interrelationships in production, marketing, procurement, and technology, defined earlier as activity sharing

when using the unrelated diversification

Firms do not seek either operational relatedness or corporate relatedness

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In addition, a diversified firm may acquire other firms that are poorly managed in order to restructure its own asset base. Knowing that their firms could be acquired if they are not managed successfully encourages executives to use value-creating diversification strategies.

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In the beginning of the twenty-first century, antitrust concerns emerged again with the large volume of mergers and acquisitions (see Chapter 7).* Mergers are now receiving more scrutiny than they did in the 1980s, 1990s, and the first decade of the 2000s

intangible resources & diversification

Intangible resources are more flexible than tangible physical assets in facilitating diversification. Although the sharing of tangible resources may induce diversification, intangible resources such as tacit knowledge could encourage even more diversification. Service firms also pursue diversification strategies especially through greenfield ventures (opening a new business for the firm without acquiring a previous established brand-name business)

summary 8

Managerial motives to diversify (including to increase compensation) can lead to overdiversification and a subsequent reduction in a firm's ability to create value. Evidence suggests, however, that many top-level executives seek to be good stewards of the firm's assets and avoid diversifying the firm in ways that destroy value.

Value-Reducing Diversification: Managerial Motives to Diversify

Managerial motives to diversify can exist independent of value-neutral reasons (i.e., incentives and resources) and value-creating reasons (e.g., economies of scope). The desire for increased compensation and reduced managerial risk are two motives for top-level executives to diversify their firm beyond value-creating and value-neutral levels.* In slightly different words, top-level executives may diversify a firm in order to spread their own employment risk, as long as profitability does not suffer excessively.

Summary 9

Managers need to consider their firm's internal organization and its external environment when making decisions about the optimum level of diversification for their company. Of course, internal resources are important determinants of the direction that diversification should take. However, conditions in the firm's external environment may facilitate additional levels of diversification, as might unexpected threats from competitors.

firms using either a related or an unrelated diversification strategy must understand the consequences of paying large premiums

Paying excessive acquisition premiums often causes managers to become more risk averse and focus on achieving short-term returns. When this occurs, managers are less likely to be concerned about making long-term investments (e.g., developing innovation). Alternatively, diversified firms (related and unrelated) can be innovative if the firm pursues these strategies appropriately.

summary4

Sharing activities is usually associated with the related constrained diversification corporate-level strategy. Activity sharing is costly to implement and coordinate, may create unequal benefits for the divisions involved in the sharing, and can lead to fewer managerial risk-taking behaviors.

Corporate-level core competencies are

complex sets of resources and capabilities that link different businesses, primarily through managerial and technological knowledge, experience, and expertise

The company using the related diversification strategy (related constrained & related linked) wants to

develop and exploit economies of scope between its businesses

Financial economies can also be created when

firms learn how to create value by buying, restructuring, and then selling the restructured companies' assets in the external market -Unrelated diversified companies that pursue this strategy try to create financial economies by acquiring and restructuring other companies' assets, but it involves significant trade-offs.

Firms using a related diversification strategy

may gain market power when successfully using a related constrained or related linked strategy

For the diversified company, a business-level strategy

must be selected for each of the businesses in which the firm has decided to compete.

corporate relatedness

opportunities for transferring corporate-level core competencies into businesses