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6-2Reasons for Diversification

A firm uses a corporate-level diversification strategy for a variety of reasons (see Table 6.1). Typically, a diversification strategy is used to increase the firm’s value by improving its overall performance. Value is 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.

Table 6.1

Reasons for Diversification

Value-Creating Diversification

· Economies of scope (related diversification)

· Sharing activities

· Transferring core competencies

· Market power (related diversification)

· Blocking competitors through multipoint competition

· Vertical integration

· Financial economies (unrelated diversification)

· Efficient internal capital allocation

· Business restructuring

Value-Neutral Diversification

· Antitrust regulation

· Tax laws

· Low performance

· Uncertain future cash flows

· Risk reduction for firm

· Tangible resources

· Intangible resources

Value-Reducing Diversification

· Diversifying managerial employment risk

· Increasing managerial compensation

Enlarge Table

Other reasons for using a diversification strategy may have nothing to do with increasing the firm’s value; in fact, diversification can have neutral effects or even reduce a firm’s value. Value-neutral reasons for diversification include a desire to match and thereby neutralize a competitor’s market power (e.g., to neutralize another firm’s advantage by acquiring a similar distribution outlet). Decisions to expand a firm’s portfolio of businesses to reduce managerial risk or increase top managers’ pay can have a negative effect on the firm’s value. Greater amounts of diversification reduce managerial risk in that if one of the businesses in a diversified firm fails, the top executive of that business does not risk total failure by the corporation. As such, this reduces the top executives’ employment risk. In addition, because diversification can increase a firm’s size and thus managerial compensation, managers have motives to diversify a firm to a level that reduces its value. Diversification rationales that may have a neutral or negative effect on the firm’s value are discussed later in the chapter.

Operational relatedness and corporate relatedness are two diversification strategies that can create value (see Figure 6.2). Studies of these independent relatedness dimensions show the importance of resources and key competencies. The figure’s vertical dimension depicts opportunities to share operational activities between businesses (operational relatedness), while the horizontal dimension suggests opportunities for transferring corporate-level core competencies (corporate relatedness). The firm with a strong capability in managing operational synergy, especially in sharing assets between its businesses, falls in the upper left quadrant, which also represents vertical sharing of assets through vertical integration. The lower right quadrant represents a highly developed corporate capability for transferring one or more core competencies across businesses.

Figure 6.2Value-Creating Diversification Strategies: Operational and Corporate Relatedness

Figure 6.2 is a model that shows value creating diversification strategies: operational and corporate relatedness. This model has four boxes placed in two rows. The box on the top left gives the related constrained diversification, the box on the top right gives both operational and corporate relatedness, the box on the bottom left gives the unrelated diversification and the box on the bottom right gives the related linked diversification. Outside, on the left of the top left box is, high; on the left of the bottom left box is, low and outside and between these two boxes is, operational relatedness: sharing activities between businesses. Outside, below the bottom left box is, low; below the bottom right box is, high and outside and between these two boxes is, corporate relatedness: transferring core competencies into businesses.

This capability is located primarily in the corporate headquarters office. Unrelated diversification is also illustrated in Figure 6.2 in the lower left quadrant. Financial economies (discussed later), rather than either operational or corporate relatedness, are the source of value creation for firms using the unrelated diversification strategy.