Chapter 6 (IE Elec 3) REASONS FOR DIVERSIFICATION

CORPORATE-LEVEL STRATEGY

Corporate Level Strategy - specifies actions a firm takes to

gain a competitive advantage by selecting and managing a
group of different businesses competing in different product
markets.

2 Types of Strategies

1. Corporate-Level

2 key issues:
a) What product markets and businesses the
firm should compete
b) How corporate headquarters should
manager their business

2. Business-Level

Product Diversification – 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.”

Successful Diversification - is expected to reduce

variability in the firm’s profitability as earnings are generated
from different businesses.

LEVELS OF DIVERSIFICATION
Value - created either through related diversification or through
unrelated diversification when the strategy allows a company’s
businesses to increase revenues or reduce costs while
implementing their business-level strategies.

2 ways diversification strategies can create Value:

1. Operational Relatedness
2. Corporate Relatedness

Conglomerates – firms using Unrelated Diversification

Strategy.
VALUE-CREATING DIVERSIFICATION: RELATED
CONSTRAINED & RELATED LINKED DIVERSIFICATION
Economies of Scope - are cost savings that the firm
creates by successfully sharing some of its 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.
2 Basic Kinds of Operational Economies
1. Sharing Activities (Operational Relatedness)
2. Transferring Corporate-level Core Competencies
(Corporate Relatedness)
OPERATIONAL RELATEDNESS
Firms can create operational relatedness through:
a) Primary Activity
b) Support Activity
CORPORATE RELATEDNESS
Corporate-level Core Competencies - complex sets of
resources and capabilities that link different businesses,
primarily through managerial and technological knowledge,
experience, and expertise
2 ways that related linked diversification helps the
firms to create value:
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 - difficult for competitors to
understand and imitate.
MARKET POWER
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
Multipoint Competition - exists when two or more
diversified firms simultaneously compete in the same
product areas or geographic markets
Vertical Inegration - exists when a company produces its
own inputs (backward integration) or owns its own source
of output distribution (forward integration).
UNRELATED DIVERSIFICATION
Financial Economies - are cost savings realized through
improved allocations of financial resources based on
investments inside or outside the firm.
Efficient internal capital allocations - can lead to financial
economies
- reduce risk among the firm’s businesses
Efficiency results as investors take equity positions
(ownership) with high expected future cash flow values.
Capital is also allocated through debt as shareholders and
debt holders try to improve the value of their investments by
taking stakes in businesses with high growth and profitability
prospects.
Informational advantages of firms with internal capital
markets
1. Information provided to capital markets through
annual reports and other sources may not include
negative information, instead emphasizing positive
prospects and outcomes. External sources of capital
have limited ability to understand the operational
dynamics of large organizations
2. Although a firm must disseminate information, that
information also becomes simultaneously available to
the firm’s current and potential competitors. With
insights gained by studying such information,
competitors might attempt to duplicate a firm’s value-
creating strategy
Highly diversified businesses often face “conglomerate
discount.” This discount results from analysts not knowing how
to value a vast array of large businesses with complex financial
reports
Restructuring of Assets
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
As the ensuing Strategic Focus on unrelated
diversified companies that pursue this strategy suggests,
creating financial economies by acquiring and restructuring
other companies’ assets involves significant trade-offs
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
Value-Neutral Diversification: Incentives
and Resources
Objectives firms seek when using related
diversification and unrelated diversification strategies all have
the potential to help the firm create value by using a corporate-
level strategy.
INCENTIVES TO DIVERSIFY
Free cash flows -liquid financial assets for which
investments in current businesses are no longer
economically viable
1. Low Performance - low returns are related to greater
levels of diversification
 2. Uncertain Future Cash Flows
As a firm’s product line matures or is threatened,
diversification may be an important defensive strategy
3. Synergy and Firm Risk Reduction
Synergy exists when the value created by business
units working together exceeds the value that those
same units create working independently

As a firm increases its relatedness between business

units, it also increases its risk of corporate failure,
because synergy produces joint interdependence
between businesses that constrains the firm’s
flexibility to respond

Basic decisions when threatened

1. firm may reduce its level of technological change by
operating in environments that are more certain
2. firm may constrain its level of activity sharing and
forgo synergy’s potential benefits

VALUE-REDUCING DIVERSIFICATION: MANAGERIAL

MOTIVES TO DIVERSIFY

2 motives for top level executives to diversify their firm

1. desire for increased compensation
2. reduced managerial risk

The greater the incentives and the more flexible the resources,
the higher the level of expected diversification.