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How do firms grow?

Mergers and Acquisitions Internal Diversification Strategic Alliance Joint ventures

What is Diversification?
Diversification is the entry of the firm into new markets and into new products Diversification when a firm is active in number of industries Diversification represents the extent to which firms operate in different businesses simultaneously Diversification is defined as the entry of a firm or business unit into new lines of activity, either by processes of internal development or acquisition which entails changes in its administrative structure, systems and management processes

Why do firms diversify?

The Market Power View
Diversified firms will thrive because they have conglomerate power. Bigness is a source of market power. Ways in which conglomerate can yield power
Cross-subsidization Mutual forbearance Reciprocal buying

Conglomerate power is a function of firms market power in its individual sections.

The Market Power View

RiskReduction Reduction Risk

Negative relationship Negative relationship between risk andbetween return

risk and return (IO View) Positive relationship between risk and return (Finance View)

Internal Market InternalCapital Capital Market Winner Picking by Headquarter

Winner Picking by Headquarter Better allocative efficiency Better allocative efficiency Reduce underinvestment risk Reduce underinvestment risk Inefficient cross subsidization Firm Performance

Inefficient cross subsidization

Agency Theory
More power and prestige Better compensation Better compensation Reduce unemployment risk Reduce unemployment risk Makes the manger indispensable for the firm Makes the No manger indispensable increase in the value of the firm for the firm

Agency Theory

More power and prestige

No increase in the value of the firm

The Agency View

When shareholders are too dispersed, managers pursue value reducing activities (diversification) to further their own interest. Why would managers do so?
Empire building Managerial Entrenchment Reduction of unemployment risk

The Resource Based view

Firms diversify in response to excess capacity of resources Excess capacity arises out of
Indivisibility of resources Same resource can be used in multiple circumstances If the firms unused resources can be efficiently sold in the market place, the rationale for diversification evaporates.

Asset specificity and diversification

The Resource Based view

Can Diversifying firms create value?

An income stream greater than what could be realized from a portfolio investment in the two or more companies A reduction in the variability of the income stream greater than that could be realized from a portfolio investments in two or more companies.

Can Diversifying firms create value?

A diversifying firm can raise productivity if knowledge acquired in one industry can be used in another industry Investments in markets closely related to current field of operations can reduce long run average costs Business expansion in an area of competence can lead to the generation of critical mass to outperform competition Diversification into related product markets can enable a conglomerate to reduce systematic risks.

Can Diversifying firms create value?

Internal capital markets in a diversified firm can reduce the need of individual businesses to obtain funds from external sources Diversified firms can reduce bankruptcy risks thereby lowering the cost of debt

How to measure diversification?

Continuous measure
35 Product Count measure 30 25 Entropy Measure Categorical Measure % of Firms 20 15 Rumelts Measure 10 Specialization ratio (SR) 5 Related ratio (RR) 0 Single Business- SR>0.95 0.1 0.3 0.5 0.7 0.9 Dominant Business-0.70<SR<0.95 Specialization Ratio Related Business-SR<0.70, RR>0.70 Unrelated Business- SR<0.70 RR<0.70

SR of 1949 SR of 1969

Do diversified firms create superior firm performance?

Diversification has a negative relationship with performance Variation in firm performance is mostly attributed to industry structure Diversification has an inverted U shaped relationship with firm performance