S Mgt Ki - Maa Ki Aankh

8/3/2019 S Mgt Ki - Maa Ki Aankh

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What is Diversification?

A collection of businesses under onecorporate umbrella

Prannoy K.K


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Introduction

Why Firms Diversify

To grow

To more fully utilize existing resources and capabilities.

To escape from undesirable or unattractive industry

environments.

To make use of surplus cash flows.


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Introduction (cont.)

Horizontal or related diversification

Strategy of adding related or similar product/service lines to

existing core business, either through acquisition of

competitors or through internal development of new

products/services.


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Horizontal or related diversification

Advantages

Opportunities to achieve economies of scale and scope.

Opportunities to expand product offerings or expand into

new geographical areas.

Disadvantages of related diversification

Complexity and difficulty of coordinating different but

related businesses.


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Conglomerate or unrelated diversification

Firms pursue this strategy for several reasons:

Continue to grow after a core business has matured orstarted to decline.

To reduce cyclical fluctuations in sales revenues and cash

flows.

Problems with conglomerate or unrelated diversification:

Managers often lack expertise or knowledge about their

firms businesses.


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Levels and Types of Diversification

Low Levels of Diversification

Single Business

> 95% of business from a single

business unit

Dominant Business

Between 70 and 95% of business

from a single business unit


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Related Constrained


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Related Linked (Mixed)

< 70% of revenues from dominantbusiness, and only limited links

exist

Moderate to High Levels of Diversification



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Unrelated

< 70% of revenue comes from thedominant business, and there are

no common links between

businesses

Very High Levels of Diversification



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RATE OF PROFIT > COST OF CAPITAL

INDUSTRY

ATTRACTIVENESS

COMPETITIVE

ADVANTAGE

Superior profit derives from two sources:

Diversification decisions involve these same two issues:

How attractive is the sector to be entered?

Can the firm achieve a competitive advantage?


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Reasons for DiversificationReasons to Enhance Strategic

Competitiveness

Economies of scope

Market power

Financial economics

Incentives

Resources

Managerial

Motives


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Resources with varying

effects on value creation and

strategic competitiveness Tangible resources

financial resources

physical assets

Intangible resources

tacit knowledge

customer relations

image and reputation

Incentives

Resources

Managerial

Motives

Reasons for Diversification


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Adding Value by DiversificationDiversification most effectively adds value by either of two

mechanisms:

Economies of scope: cost savings attributed to transferring the

capabilities and competencies developed in one business to a new

business

Market power: when a firm is able to sell its products above the

existing competitive level or reduce the costs of its primary and

support activities below the competitive level, or both


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Incentives with Neutral

Effects on Strategic

Competitiveness Anti-trust regulation

Tax laws

Low performance

Uncertain future cash flows

Firm risk reduction

Incentives

Resources

Managerial

Motives



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Incentives to Diversify

Internal Incentives:

Poor performance may lead some firms to diversify an attempt

to achieve better returns

Firms may diversify to balance uncertain future cash flows

Firms may diversify into different businesses in order to reduce

risk


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Managerial Motives (Value

Reduction)

Diversifying managerialemployment risk

Increasing managerial

compensation

Incentives

Resources

Managerial

Motives



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Managerial Motives to

Diversify

Managers have motives to diversify

diversification increases size; size is associated with executive

compensation

diversification reduces employment risk

effective governance mechanisms may restrict such motives


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Motives for Diversification

GROWTH --The desire to escape stagnant or declining industriesa powerful motives for diversification (e.g. tobacco,oil, newspapers).

--But, growth satisfies managers not shareholders.

--Growth strategies (esp. by acquisition), tend todestroy shareholder value

RISK --Diversification reduces variance of profit flowsSPREADING --But, doesn't create value for shareholdersthey can

hold diversified portfolios of securities.--Capital Asset Pricing Model shows that diversification

lowers unsystematic risknot systematic risk.

PROFIT --For diversification to create shareholder value, thenbringing together of different businesses undercommon ownership & must somehow increase

their profitability.


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WHEN DOES DIVERSIFICATION

START TO MAKE SENSE?

Strong competitive position,

rapid market growth -- Not a

good time to diversify

Strong competitive position,

slow market growth --

Diversification is top priority

consideration

Weak competitive position,

rapid market growth -- Not a

good time to diversify

Weak competitive position,

slow market growth --

Diversification merits

consideration


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Diversification and Shareholder Value:Porters Three Essential Tests

If diversification is to create shareholder value, it must meetthree tests:

1. The Attractiveness Test: diversification must be directedtowards actual or potentially-attractive industries.

2. The Cost of Entry Test: the cost of entry must not capitalizeall future profits.

3. The Better-Off Test: either the new unit must gaincompetitive advantage from its link with the corporation, orvice-versa.


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Strategies for Diversification

1.Acquire existing firm in targetindustry

2. Start new company internally

3. Form joint venture


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Conclusions

Size alone does not guarantee firms an advantage.

Coordination required to exploit economies of scale

and scope is not without cost.

Size creates additional challenges and difficulties,

including problems of communication and

coordination.

Higher levels of diversification are not incompatible with

high performance -- nor do they necessarily imply that

firms will suffer lower performance levels.


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Conclusions (cont.)

Critical factor in determining success is the level of

management expertise in formulating and implementing

corporate strategy.

More difficult for diversified firms.

Managers of large diversified firms possess a variety of

well-developed mental models that provide them with

powerful understandings of how to manage their firms.


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When to Stop Diversifying

When you achieve acceptable levels of growth and

profitability

Before complexity outstrips management's ability to manage


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Restructuring

A strategy through which a firm changes its set of businesses

or financial structure

Failure of an acquisition strategy often precedes a

restructuring strategy

Restructuring may occur because of changes in the

external or internal environments

Restructuring strategies:

Downsizing

Downscoping

Leveraged buyouts

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