1 -1-

Hitt, Ireland and Hokinsson

CORPORATE STRATEGY, VERTICAL INTREGRATION,

DIVERSIFICATION, AND STRATEGIC ALLIANCE

The primary concern of corporate strategy is identifying the business areas in which a
company should participate in order to maximize its long-run profitability.

Concentration on a Single Business

Some companies tends to concentrate on one single business (that is focusing on one
single industry or market) examples of such companies are Coca-Cola and McDonalds
which focuses on drinks business and fast-food restaurant business.

Advantages of Single Business

 The company can focus all its resources and capabilities on competing successfully in
a single market
 The company will be better able to survive where there is a great demand for its
limited resources.
 The company also “stick to its knitting”, that is the company stick to what it knows
best or what its core competence is in.

Disadvantages
 Companies that concentrate on one single business could be loosing out on great
profit in other areas of business.
 If the demand for the one product that you are in fails the company could find itself
out of business.
 Diversification can help create value by allowing a company to leverage valuable
resources and capabilities across businesses.

Vertical Integration

A strategy of vertical integration means that a company is producing its own input or the
company is disposing of its own output.

 Backward Integration – this is where the company is producing its own input.
 Forward Integration – This is where the company is disposing of its own output.
1 -2-

 Full Integration – This is where a company is produces all the particular input needed
for its processes or where it disposes of all the output through its own operations.
 Taper Integration – This is where the company buys from independent supplier in
addition to company owned suppliers as well as disposing of output through
independent outlet as well as company owned outlet.

Creating Value Through Vertical Integration

There are four main arguments for pursuing vertical strategy these are:
 Building Barriers to entry – When a company has backward and forward
integration strategies it will make it difficult for new entrants to enter the market and
thereby are able to charge premium price.

 Facilitating Investments in Specialized Assets – A company might find it difficult

to persuade other companies in the adjacent stages in the raw material to consumer
production to undertake production in specialized assets. Therefore the company
might find that based on the reliance on those input it will have to invest in those
specialized assets itself to create value for the organization.

 Protecting Product Quality - By protecting service quality, vertical integration

enables a company to become a differentiated player in its core business.

 Improved Scheduling – It is argued that strategic advantage advantages arise from

the easier planning, coordination and scheduling of adjacent processes in vertical
integrated organization. (Just-in-time inventory). Integration enhances scheduling by
allowing companies to respond better to sudden changes in demand.

Arguments against Vertical Integration

 Costs Disadvantages – Companies might find themselves stuck to high costs

associated with vertical integration, when there are cheaper sources available.
 Technological Changes – when technology is changing fast vertical integration poses
the hazard of tying a company to an obsolescent technology.
 Demand Uncertainty – Vertical integration can be risky in unstable or unpredictable
demand conditions

Bureaucratic Costs and the Limits of Vertical Integration

Bureaucratic costs are the costs associated with the running of an organization. Vertical
integration may inhibit the reduction of bureaucratic costs as there might not be any
incentive on the part of a company owned supplier to reduce operating costs by a possible
lack of strategic flexibility in times of changing technology, or uncertain demands.

Alternative to Vertical Integration: Cooperative

Relationships and Strategic Outsourcing.
1 -3-

Short – Term Contract and Competitive Bidding

A short-term contract is one that lasts for a year or less this strategy facilitates
competitive bidding and will force suppliers to keep their prices down if they want to win
contracts.

Strategic Alliances and Long-term Contracting

Long-term contracts are long-term cooperative relationships between two or more

companies.

Building Long-Term Cooperative Relationship

This relationship is done in the following ways:

 Hotage Taking – This is where the partners to a contract guarantee to keep their side
of the bargain.
 Credible Commitments – A credible commitment is a believable commitment to
support the development of long-term relationship between companies.
 Maintaining Market Discipline – A company entering into a long-term cooperative
relation must not become complacent and hence inefficient because they know their
market is safe. They should there seek to maintain market discipline.

Strategic Outsourcing and the Virtual Corporation

The opposite to vertical integration is outsourcing value creation activities to sub-

contractors. When a company pursues extensive strategic outsourcing it said that a
Virtual Corporation is formed.

Diversification

There are two main types of diversification:

 Related Diversification- This is diversification into a new business activity that is

linked to a company’s existing business activity or activities by commonality between
one or more components of each activity’s value chain. (Usually these linkages are
based on marketing, manufacturing and technological commonality.
 Unrelated Diversification – is a diversification into new business areas which has no
obvious connection with any of the company’s existing areas.

Creating Value through Diversification

There are three main ways how diversification can create value:
1 -4-

 Through Superior Internal Governance – This refers to the manner in which the top
executive of the company manage (or govern) subunits and individuals within the
organization.

 Transferring Competencies – Companies that based their diversification strategy on

transferring competencies seek out new business related to their existing business by
one ore more value creation functions (eg manufacturing, marketing and material
management).

 Economies of Scope – The sharing of such resources such as manufacturing facilities

distribution channels, advertising campaign costs by two or more business units give
rise to economies of scope.

Bureaucratic Costs and the Limits of Diversification

One reason for the failure of diversification to achieve its aim is that the bureaucratic
costs of diversification often exceed the value created by the strategy. The level of
bureaucratic costs in diversified organization is function of two factors.
 Number of businesses
 Coordination among businesses

Diversification that Dissipates Value

The failure of diversification to create value is due largely to the fact that company
diversify for the wrong reason. This is true of diversification that are done to
a. Pool risks or – The benefits are said to come from merging imperfectly correlated
income stream to create more stable income stream.
b. To achieve greater growth – Diversification to create growth is not a coherent
strategy as growth on its own does not create value. Growth should be a by-products,
not the objective of the diversification strategy.

Related versus Unrelated Diversification

One issue companies must resolve is whether to diversify into totally new business or
business relating to existing business by value chain commonalties. The decision is
between related and unrelated diversification. It is said that related diversification is less
risky than unrelated diversification as top management tends to know the field that they
are in. This is so because of:
 The number of businesses in the company’s portfolio.
 The extent of coordination required among the different businesses in order to realize
value from a diversified strategy.
1 -5-

CORPORATE DEVELOPMENT: BUILDING

AND RESTRUCTURING THE CORPORATION

Corporate Development is concerned with identifying which business opportunities a

company should pursue, how it should pursue those opportunities and how it should exit
from the business that do not fit the company’s strategic vision.

Reviewing the Corporate Portfolio (Boston Consultancy Group) BCG

Reviewing corporate portfolio helps to identify which business the company should
continue to participate in, which it should exit from and whether the company should
consider entering any new business areas. There are two main approaches:

 The portfolio planning matrices – This is where there is a competitive comparison of

different businesses within the portfolio against each other on the basis of common
criteria. Portfolio planning entails:
a. Dividing the company into strategic business units (Product market)

b. Accessing the prospects of each SBU and compare them against each other by means
of a matrix. The assessing is done on two basis:
(1) Each SBU relative market share and this is the ratio of an SBU’s market share to the
market share held by the largest rival company in the industry.

(2) The growth of the SBU’s industry. The matrix is divided into four cells:
 Stars - The leading SBU’s in a company’s portfolio are the stars

 Question marks – These are SBU’s that are relatively weak in competitive terms (they
have low relative market share) but are based in high growth industries and thus are
considered opportunities. These can become stars if nurtured properly.

 Cash Cows – SBU.s that have high market share in low growth industry and a strong
competitive position in mature industry.

 Dogs – These are SBU’s that are in low growth industry and have a low market share.

c. Develop strategic objectives for each SBU.

(1) The cash surplus from any cash cows should be used to support the development of
selected question marks and nurture stars.
1 -6-

(2) Question Marks that are weakest and most uncertain should be divested to reduce
demands on company’s cash resources.
(3) Exit SBU’s that are dogs.
(4) If the company lacks enough stars, cash cows and question marks then it should
consider acquisition or divestments to have a balanced portfolio.

Limitations of Portfolio Planning

 The model is simplistic

 The connection between relative market share and cost savings is not as
straightforward.
 A high market share in a low growth industry does not necessarily result in the large
positive cash flow.
 It does not take industry size, growth, cyclicality, competitive industry and technical
dynamism.

The Corporation as a Portfolio of core Competencies

 Re-conceptualizing of a company as a portfolio of core competencies as opposed to

portfolio of businesses. (Gary Hamel and C.K. Prahalada). In other words Corporate
Development is geared towards maintaining existing competencies, building new
competencies and leveraging competencies by applying them to new business
opportunities.

Hamil and Prahalad maintains that identifying current core competencies is the first step
to take for a company engaged in the process of deciding which business opportunities to
pursue. Once the company has identified the core competencies then it can apply the
competencies to the quadrant matrix. This entails:

Fill in the Blanks – This refers to the opportunity to improve the company’s competitive
position in existing markets by leveraging existing core competencies.

Premier Plus 10 – What new core competencies must be built today to ensure that the
company remains a premier provider of its existing products in ten years time.

White Spaces – The question is how to fill these white spaces by creatively redeploying
or recombining current core competencies.

Mega-Opportunities – What new core competencies would we need to build to participate

in the most exiting market of the future? Nevertheless, a company may choose to pursue
such opportunities if they are seen to be particularly attractive, significant or relevant to
the company’s existing business.
1 -7-

Entry Strategy

Entry Strategy are usually done through three different strategies:

 Internal Venturing
 Acquisition
 Joint Ventures

Internal New Ventures

Internal New Venturing is an entry strategy that is used when a company posses a set of
valuable competencies (resources and capabilities) in its existing business that can be
leveraged or recommended to enter the new business areas.

Pitfalls of Internal New Venturing

 Scale of Entry – Research as shown that an average large-scale entry into a new
business is often a critical pre-condition of new venture success. Although in the
short-run large-scale entry means significant development costs and substantial
losses in the long run it brings greater returns than small-scale entry.
This is so because the large venture will benefit from economies of scale, brand
loyalty and better access to distribution channels.

 Commercialization -
 Poor Implementation

Guidelines for Successful Internal Venturing

 Effective Research and Development

 Set up Project Teams
 Use resources effectively and efficiently
 Manage internal ventures carefully
 Finally the association of large-scale entry is more effective than small scale entry

Acquisition as an Entry Strategy

 Companies often use acquisition to enter a business area that is new to them when
they lack important competencies (resources and capabilities) required to compete
in that area, but when they can purchase an incumbent company that has those
competencies at a reasonable price.
 Acquisition is the preferred choice when there is a need to move fast
 Acquisition is also used when the industry to be entered is well established and
the incumbent companies enjoy significant protections from barriers to entry.
 Acquisition is also perceived to be less risky than new ventures as there are more
certainty as to the business you are entering.
1 -8-

Pitfalls of Acquisitions

 Companies often find it difficult to merge divergent corporate culture

 Companies often overstate the potential economic benefits from an acquisition
 Acquisition tends to be very expensive
 Companies often do not adequately screen their acquisition targets.
Guidelines for Successful Acquisition

 Target identification and pre-acquisition screening

 Bidding Strategy
 Integration

Joint Ventures as an Entry Strategy

Restructuring

Why Restructure

Exit Strategies
 Divestments
 Harvesting and Liquidation

Turnaround Strategies

Turnaround entails restructuring the business operation by divesting operations that are
not creating value for the organization and sticking to one’s core-competence.

The Causes of Corporation Decline

 Poor management
 Inadequate Financial Controls
 Over expansion
 High Costs
 New Competition
 Unforeseen Demand Shifts
 Organizational Inertia

The main steps of Turnaround

 Changing the Leadership
 Redefining the Strategic Focus
1 -9-

 Assets Sales and Closures

 Improving Profitability
 Acquisition

ACQUISITION, MERGERS AND RESTRUCTURING STRATEGIES

Merger – is a strategy through which two firms agree to integrate their operations on a
relatively co equal basis.

Acquisition – is a strategy through which buys a controlling or 100% interest in another

firm with the intent of making the acquired firm a subsidiary business within its portfolio.

There are four (4) types of acquisition:

 Horizontal Acquisition – The acquisition of a firm competing in the same industry
in which the acquiring firm competes.
 Vertical Acquisition – A firm acquiring a supplier or distributor of one or more of
its goods and services.
 Related Acquisition – The acquisition of a firm in a highly related market
 Unrelated Acquisition – The acquisition of a firm in a totally unrelated market.

Takeover – is a special type of an acquisition strategy wherein the target firm does not
solicit the acquiring firm’s bid. (Hostile Takeover).

Reasons for Acquisition

 Increase Market Power

 Overcoming Entry Barriers
 Cost of New Product Development and Increase Speed of Market
 Low Risk Compared to Developing New Products
 Increased Diversification
 Reshaping the Firms Competitive Scope
 Learning and developing New capabilities
1 - 10 -

Problems in Achieving Acquisition Success

 Integration Difficulties
 Inadequate evaluation of Targets
 Large-extraordinary debts
 In ability to achieve synergy
 Too much Diversification
 Managers overly focus on diversification
 To Large
 Inadequate skills to deal with diversified industry.

Effective Acquisition

 Complimentary Resources and Assets

 Conduct effective Due Diligence
 Acquiring has financial slack (cash or favourable debt position)
 Merged firms maintains low debt position
 Acquiring firm has consistent and sustained emphasis on R&D and innovation
 Acquiring firm manage change well

REENGINEERING AND RESTRUCTURING

Reengineering and Engineering

Reengineering is the fundamental rethinking and radical redesign of business processes

to achieve dramatic improvements in critical contemporary measures of performance
such as:
 Costs
 Quality
 Service and
 Speed

Business Process is any activity that is vital to delivering goods and services to customers
quickly or that promotes high quality or low costs, these include:
 Order Process
 Inventory Control
 Product Design
Reengineering focuses on business process and not on functions, an organization that
reengineers always has to adopt a different approach to organizing its activities. That is
reengineering ignores ignore deliberately the existing arrangement of tasks, roles, and
work activities.
1 - 11 -

Restructuring

Restructuring has two basic steps:

 The organization reduces its level of differentiation and integration by eliminating
divisions, departments or levels of hierarchy.
 An organization downsizes by reducing the number of employees to decrease
operating costs.

The reasons for restructuring are:

 Shift in technology that makes a company’s product obsolete.
 Or a worldwide recession reduces the demand for its products
 A company may find itself with excess capacity because customers no longer
want the goods and services it provides, viewing them as out dated or of poor
value for money.
 Sometimes organizations downsize because they have grown excessively tall and
bureaucratic and operating costs have skyrocketed.
 Companies may also restructure to improve competitive advantage.

How to Effect Change

One thing that is certain in life is change, therefore you must know how to manage it.
Change should be effected through a three step process:
 Unfreezing
 Change
 Re-freezing

Corporate Governance

Corporate Governance represents the relationship among stakeholders that is used

to determine and control the strategic direction and performance of organizations.

Corporate Governance focuses on three main areas:

Internal Governance Mechanisms

(1) Ownership Concentration – Relative amount of stock owned by

individual shareholders and institutional investors.
1 - 12 -

(2) The Board of Directors – Individual responsibilities for representing the

firm’s owners by monitoring top-level managers’ strategic decisions

(3) Executive Compensation – Use of Salary, bonuses, and long-term

incentives to align managers’ interest with shareholders interest.

External Governance Mechanism

Market of Corporate Control – The purchase of a company that is

underperforming relative to industry rivals in order to improve the firm’s
strategic competencies.

Separation of Ownership and Managerial Control

 Agency Relationship – Agency relationship exist when one or more persons (the
principal or principals) hire another person or persons (agent or agents) as
decision making specialist to perform a service. Problems associated with the
separation of ownership and management control are:
a. Different Interest between the Owner and Manager
b. Different Goals
c. Shareholder lacks direct control.
d. Manager makes decisions that are in conflict with those of the Principal Owners
e. Managerial Opportunism – The seeking of self interest with guile(ie. Cunning or
deceit).

 Product Diversification as an Example of Agency Problem – Managers might

want to diversify the operations of the organization, while Owners might not be
too keen on the diversification of the operations of the organization due to the
inherent risks associated with diversification.
 Agency Costs and Governance Mechanism – Agency costs are the sum of
incentive costs, monitoring costs, enforcement costs, and individual financial
losses incurred by principal because governance mechanisms cannot guarantee
total compliance by the agent.

Ownership Concentration

Ownership concentration is defined by both the number of large blocks

shareholders and the total percentage of shares they own.
1 - 13 -

Large –block shareholders typically own at least 5 percent of a corporation’s issued

shares.

The Growing Influence of Institutional Owners – are financial institutions such as

stock mutual funds that control large –block shareholder position.

Shareholders Activism - How active are the shareholders of an organization.

BOARD OF DIRECTORS

The Board of Directors is a group of elected individuals whose primary responsibility is

to act in the owners’ interest by formally monitoring and controlling the corporation’s
top-level executives.

Classification of Board of Directors’ Members

Insider – The firms CEO and other top level managers

Related Outsider – Individuals not involved with the firm’s day-to-day operations, but
who have a relationship with the company.

Outsider – Individual who are independent of the firm in terms of day-to-operations and
other relationships.

Enhancing the Effectiveness of The Board of Directors

 Increase the diversity of the backgrounds of board members

 Strengthening of internal management and accounting control systems
 The establishment and consistent use of formal processes to evaluate the boards
performance.

EXECUTIVE COMPENSATION

Executive Compensation is a governance mechanism that seeks to align the interest of

managers and owners through salaries, bonuses, and long-term incentives compensation,
such as stock awards and options.

MARKET FOR CORPORATE CONTROL

1 - 14 -

The market for corporate control is an external governance mechanism that becomes
active when firms internal controls fail.

 Hostile Takeover
 Leverage Buy out

Diversification

CORPORATE DIVERSIFICATION

What is Corporate Diversification

A firm implements a corporate diversification strategy when it operates in multiple

industries or markets simultaneously.

 A firm is pursuing a product diversification product when it operates in

multiple industries simultaneously.

 When a firm operates in multiple geographic markets simultaneously, it is said to

be implementing a geographic market diversification.

 When a firm implements both types of diversification simultaneously, it is said to

be implementing a product market diversification.

There are two main types of diversification:

 Related Diversification- This is diversification into a new business activity that is

linked to a company’s existing business activity or activities by commonality between
one or more components of each activity’s value chain. (Usually these linkages are
based on marketing, manufacturing and technological commonality.
 Unrelated Diversification – is a diversification into new business areas which has no
obvious connection with any of the company’s existing areas.

Creating Value through Diversification

There are three main ways how diversification can create value:
1 - 15 -

 Through Superior Internal Governance – This refers to the manner in which the top
executive of the company manages (or govern) subunits and individuals within the
organization.

 Transferring Competencies – Companies that based their diversification strategy on

transferring competencies seek out new business related to their existing business by
one ore more value creation functions (eg manufacturing, marketing and material
management).

 Economies of Scope – The sharing of such resources such as manufacturing facilities

distribution channels, advertising campaign costs by two or more business units give
rise to economies of scope.

Bureaucratic Costs and the Limits of Diversification

One reason for the failure of diversification to achieve its aim is that the bureaucratic
costs of diversification often exceed the value created by the strategy. The level of
bureaucratic costs in diversified organization is function of two factors.
 Number of businesses
 Coordination among businesses

Diversification that Dissipates Value

The failure of diversification to create value is due largely to the fact that company
diversify for the wrong reason. This is true of diversification that are done to
c. Pool risks or – The benefits are said to come from merging imperfectly correlated
income stream to create more stable income stream.
1 - 16 -

d. To achieve greater growth – Diversification to create growth is not a coherent

strategy as growth on its own does not create value. Growth should be a by-products,
not the objective of the diversification strategy.

Related versus Unrelated Diversification

One issue companies must resolve is whether to diversify into totally new business or
business relating to existing business by value chain commonalties. The decision is
between related and unrelated diversification. It is said that related diversification is less
risky than unrelated diversification as top management tends to know the field that they
are in. This is so because of:
 The number of businesses in the company’s portfolio.
 The extent of coordination required among the different businesses in order to realize
value from a diversified strategy.

STRATEGIC ALLIANCES

Strategic alliances are cooperative strategies between firms whereby resources and
capabilities are combined to create a competitive advantage. All strategic alliances
require firms to exchange and share resources and capabilities to co-develop or distribute
goods or services.

The three basic types of strategic alliances are:

 Joint Ventures, where a legally independent company is created by at least two other
firms, with each firm usually owning an equal percentage of the new company;
1 - 17 -

 Equity Strategic Alliances, whereby partners own different percentages of equity in

the new company they have formed;

 Nonequity Strategic Alliances, which are contractual relationships between firms to

share some of their resources and capabilities. The firms do not establish a separate
organization, nor do they take an equity position. Because of this, nonequity strategic
alliances are less formal and demand fewer partner commitments than joint ventures
and equity strategic alliances. Typical forms are licensing agreements, distribution
agreements and supply contracts.


Barney

Chapter 7

CORPORATE DIVERSIFICATION

What is Corporate Diversification

A firm implements a corporate diversification strategy when it operates in

multiple industries or markets simultaneously.
1 - 18 -

 A firm is pursuing a product diversification product when it operates

in multiple industries simultaneously.

 When a firm operates in multiple geographic markets simultaneously,

it is said to be implementing a geographic market diversification.

 When a firm implements both types of diversification simultaneously,

it is said to be implementing a product market diversification.

Types Corporate Diversification

There are three main types of diversification, these are:

 Limited Corporate Diversification – A firm has implementing a

strategy of Limited Corporate Diversification when all of or most of
its business activities fall within a single industry and geographic
market. Two types of firms are included in this corporate
diversification category

a. Single Business Firms – These are firms with greater than 95% of
their total sales is in a single product market

b. Dominant Business Firms – These are firms with between 70% and
95% of their total sales in a single product market.

 Related Corporate Diversification – A firm is engaged in Related

Corporate Diversification when less than 70% of a firms revenue
comes from a single product market and these multiple lines of
business are linked. The multiple business that a diversified firm
pursue can be related in two ways:

a. Related Constrained – This is where, if all the business in which a firm

operates share a significant number of inputs, production
technologies, distribution channels and similar customers. Example
PepsiCo, although Pepsi operates in multiple business around the world,
1 - 19 -

all its businesses focus on snack type products, either food or

beverages.

b. Related Linked – Related Link exist if the different businesses that a

single firm pursues are linked on only a couple of dimensions.

 Unrelated Corporate Diversification - This is where a firm pursues

numerous different businesses and there are no linkages among them.

The Value of Corporate Diversification

For corporation diversification to be economically valuable, to condition

must hold.
These are:

 First there must be some valuable economy of scope among multiple

businesses in which a firm is operating.

 Second it must be less costly for managers in a firm to realize these

economies of scope than for outside equity holders on their own.

What are Valuable Economics of Scope?

Economics of scope exist in a firm when the value of the products or

services it sells increases as a function of the number of businesses in which
a firm operates. Economies of scope are valuable to the extent that they
increase a firm’s revenue or decrease its costs, compared to what would be
the case if these economies of scope were not exploited. There are
different types of economies of scope these are:

 Operational Economies of Scope

a. Shared Activities – The value chain analysis can be used to describe

business activities that may be shared across several different
businesses within diversified firms.
1 - 20 -

b. Core competencies – is defined as the collective learning in the

organization, especially how to coordinate diverse production skills and
integrate multiple streams of technologies.

 Financial Economies of Scope

a. Internal Capital Allocation - Capital can allocated to business in one

of two ways. First, business operating as independent entities can
compete for capital in external capital market.

b. Risk Reduction - The riskiness of the cash flows of diversified firms

is lower than the riskiness of the cash flows of undiversified firms.
(All the business will not be doing badly at the same time.

c. Tax Advantages -

 Anti-competitive Economies of Scope

a. Multipoint competition – Multipoint competition exists when two or

more diversified firms simultaneously compete in multiple markets.
Example HP and Dell compete in both the personal computer market
and the market for computer printers.

b. Exploiting Market Power – International allocation of capital among a

diversified firm’s businesses may enable in some of the businesses the
market power advantages it enjoys in other of its business.

 Employee and Stakeholders Incentive for Diversification

a. maximizing management compensation

Corporate Diversification and Sustained Competitive Advantage

In order for diversification to be a source of competitive advantage it must

not only be valuable, but also rare and costly to imitate and a firm must be
organized to implement this strategy.
1 - 21 -

 Rarity of Diversification – The rarity of diversification depends not on

diversification per se but on how rare the particular economies of
scope associated with that diversification are. If only few competing
firms have exploited a particular economy of scope, that economy of
scope can be rare. If numerous firms have done so, it would be
common and not a source of competitive advantage.

 The Inability of Diversification – both forms of imitation, direct

duplication and substitution are relevant in evaluating the ability of
diversification strategies to generate sustained competitive
advantage, even if the economy of scope that they generate is rare.

Chapter 8

ORGANIZING TO IMPLEMENT CORPORATE DIVERSIFICATION

Organizational Structure and Implementing Corporate diversification

The most common organizational structure for implementing corporate

diversification strategy is the Multidivisional structure (M-form). In the
multiple divisional structures each firm is managed through a division. (See
organizational chart on page 222).
1 - 22 -

The M –form structure is designed to create checks and balances for

managers that increase the probability that a diversified firm will be
managed in ways consistent with the interest of the equity holders.

The Board of Directors

One of the major components of an M-form organization is a firm’s Board of

Directors. In principle, all the firm’s senior managers reported to the
Board. A Board of Directors typically consist of 10-15 individuals drawn from
individual outside the firm.

The firm’s Senior Executives such as the CEO, CFO are usually on the board.
The Board of directors are typically organized into several committees such
as:
 Audit Committee
 Finance Committee
 Nominating Committee
 Personal and Compensation Committee

Institutional Owners

Institutional Owners are can be a single investor or it can be small blocks of

millions of investors.

Institutional owners usually include:

 Pension Funds
 Mutual funds
 Insurance Companies
 Other group of individual investors who joined together to manage
their portfolio.

The Senior Executives

1 - 23 -

The Senior Executives are responsible for the following:

 Strategy Formulation – Strategy formulation entails deciding which
set of businesses a diversified firm will operate in.
 Strategy Implementation – Strategy implementation focuses on
encouraging behaviour in a firm that is consistent with this strategy.

Corporate Staff

The primary responsibility of Corporate Staff is to provide information

about the firms’ external and internal environment to the senior executives.
This information is vital for both the strategy formulation and
implementation.

Divisional General Manager

Divisional General Manager in a Multidivisional Firm has primary

responsibilities for managing the firms business from day to day. Divisional
General Managers have full profit-and- loss responsibility and typically have
multiple functional managers reporting to them.

Shared Activity Manager

Shared activities managers create economy of scope when one or more of

the stages in their value chain are managed in common. Eg two or more
division in a multidivisional firm including common sales forces, common
distribution system, common manufacturing facilities and common research
and development effort share the same manager. The primary responsibility
of the individual who manage the shared activities is to support the
operation of the division that share the activity. This include

 Shared Activity and Cost centre – Shared Activities are often

managed as cost centres in an M-form structure, ie rather than having
profit an loss responsibility, cost centre are assigned a budget and
manage their operation to that budget.
 Shared Activity and Profit Centre – Some diversified firms are
beginning to manage shared activities as profit centres rather than
cost centres. Rather than requiring division to use the services of
1 - 24 -

shared activities, instead the division have to purchase the services

of internal shared activities.

Management Controls and Implementing Corporate Diversification

The most important management controls structure includes:

 Evaluating Divisional Performance – This is done in terms of the
division profitability or if the division is making a loss. The questions
are (1) how should division profitability be measured? (2) How should
economy of scope linkages between divisions be factored into
divisional performance measures? The measures used to measure
performance are:
a. Accounting Measures and Divisional Performance
b. Economic Measures and Divisional Performance (EVA)

 Allocating Corporate Capital – Budgeting with special emphasis on Zero

Based Budgeting. This is where corporate executive create a list of all
capital allocation request from all divisions in the firm, then rank them
from most important to least important and then allocate the funds
accordingly.

 Transferring Intermediate Products – Intermediate products or

services are those product or services produced in one division are
used as input for products produced in a second division. This is
usually managed through a transfer pricing system. This is where
one division “sells” the intermediate product or services to the second
department at a transfer price.

CHAPTER # 10

MERGERS AND ACQUISITIONS

1 - 25 -

WHAT ARE MERGERS AND ACQUISITIONS?

The terms mergers and acquisitions are often used interchangeably, even
though they are not synonyms.
 Acquisition – A firm is engaged in acquisition when it purchases a
second firm. The acquiring firm however must enough shares (51%)
which will allow the acquiring firm to make all the management and
strategic decisions in the targeted firm. There are several types of
acquisitions, these are:
a. Friendly Acquisition – This is where management of the targeted firm
wants the firm to be acquired
b. Unfriendly Acquisition – This is where management of the targeted
firm does not want the firm to be acquired.
c. Hostile takeovers – These are unfriendly acquisitions, however, in
most cases the management of the firm being acquired are not aware.

 Mergers – Mergers are, when the assets of two similar-sized firms

are combined to form one company. In mergers one company
purchases some percentage of the second firm’s assets while the
second firm simultaneously purchases some percentage of the first
firm assets. Mergers can also be friendly or unfriendly, however, in
most instances mergers will be friendly. Eg National Commercial Bank
(NCB) and Mutual Security Bank (MSB) in the mid 1990s.

THE VALUE OF MERGERS AND ACQUISITION

Merger and acquisition strategies are very important strategic option open
to firms pursuing diversification and vertical integration strategies. The
discussion as to how value is created through mergers and acquisition can be
divided in two areas:

 Mergers and Acquisition: The Unrelated Case - Please read on page

(279)

 Mergers and Acquisitions: The Related Case

1 - 26 -

There are three types of strategic relatedness

a. The Federal Trade Commission categories. This includes:
1) Vertical Mergers- A firm acquires former suppliers or customers
2) Horizontal Mergers - A firm acquires a former competitor
3) Product Extension Merger– A firm gains access to complementary
products
4) Market Extension Merger – A firm gains access to complementary
markets through an acquisition
5) Conglomerate Mergers – There is no strategic relatedness between
bidding and a target market.

b. Potential Source of Strategic relatedness between Bidding and Target

Firms:
1. Technical Economies – Scale economies that occur when the physical
processes inside a firm are altered so that the same amounts of input
produced a higher quantity of output. Sources of technical economies
include marketing, production, experience, scheduling, banking and
compensation.
2. Pecunary Economies – Economies achieved by the ability of firms to
dictate prices by exerting market power.
3. Diversification Economies – Economies achieved by improving a firms
performance relative to its risk attributes or lowering its risk
attributes relative to its performance.

c. Why Bidding Firms might wan to engage in mergers and acquisition

strategies
1. To Reduce Production and Distribution Costs, through
- Through economies of scale
- Through vertical integration
- Through the adoption of more efficient production and organizational
technology
- Through the increased utilization of the bidder’s management team
- Through a reduction of agency costs by bringing organization –
specific assets under common ownership.

2. Financial Motivation
- To gain access to underutilized Tax shields
1 - 27 -

- To avoid bankruptcy costs

- To increase leverage opportunities
- To gain other tax advantages
- To gain market power in product markets
- To eliminate inefficient target management

WHY ARE THERE SO MANY MERGERS AND ACQUISITIONS?

 To ensure Survival
 Free cash Flow
 Agency Problems
 Managerial Hubris – This is where the management of the bidding firm
believe that they can better manage the assets of the target firm
more efficiently than the target firm.
 The potential for above-normal profits

MERGER AND ACQUISITIONS AND SUSTAINED COMPETITIVE

ADVANTAGE

 Valuable, Rare and Private Economies of Scope

 Valuable, Rare and Costly-to-Imitate Economies of scope
 Unexpected Valuable Economies of Scope Between Bidding and Target
Firms

Implications for Bidding Firm Manager

1. Search for valuable and rare economies of scope

2. Keep information away from other bidders
3. Keep information away from targets
4. Avoid winning bidding wars
1 - 28 -

5. Close the deal quickly

6. Operate in “thinly traded” acquisition markets.

Implications for target Firms Manager

1. Seek information from bidder

2. Invite other bidders to join bidding competition
3. Delay, but Do Not Stop, the Acquisition

ORGANIZING TO IMPLEMENT A MERGER OR ACQUISITION

 Post Merger Integration and Implementing a Diversification Strategy

(refer to handout given to you in class)
 Special Challenges in Post Merger Integration (refer to handout given
to you in class)
Diversification

A firm implements a corporate diversification strategy when it operates in

multiple industries or markets simultaneously.

There are two main types of diversification:

 Related Diversification- This is diversification into a new business

activity that is linked to a company’s existing business activity or
activities by commonality between one or more components of each
activity’s value chain. (Usually, these linkages are based on marketing,
manufacturing and technological commonality.

 Unrelated Diversification – is a diversification into new business areas

which has no obvious connection with any of the company’s existing areas.

Creating Value through Diversification

There are three main ways how diversification can create value:
1 - 29 -

 Through Superior Internal Governance – This refers to the manner in

which the top executive of the company manages (or govern) subunits and
individuals within the organization.

 Transferring Competencies – Companies that based their diversification

strategy on transferring competencies seek out new business related to
their existing business by one or more value creation functions (eg
manufacturing, marketing and material management).

 Economies of Scope – The sharing of such resources such as

manufacturing facilities distribution channels, advertising campaign costs
by two or more business units give rise to economies of scope.

Bureaucratic Costs and the Limits of Diversification

One reason for the failure of diversification to achieve its aim is that the
bureaucratic costs of diversification often exceed the value created by the
strategy. The level of bureaucratic costs in diversified organization is
function of two factors.
 Number of businesses
 Coordination among businesses

Diversification that Dissipates Value

The failure of diversification to create value is due largely to the fact that
company diversify for the wrong reason. This is true of diversification that
are done to
e. Pool risks or – The benefits are said to come from merging imperfectly
correlated income stream to create more stable income stream.
f. To achieve greater growth – Diversification to create growth is not a
coherent strategy as growth on its own does not create value. Growth
should be a by-products, not the objective of the diversification
strategy.
1 - 30 -

Related versus Unrelated Diversification

One issue companies must resolve is whether to diversify into totally new
business or business relating to existing business by value chain
commonalties. The decision is between related and unrelated diversification.
It is said that related diversification is less risky than unrelated
diversification as top management tends to know the field that they are in.
This is so because of:
 The number of businesses in the company’s portfolio.
 The extent of coordination required among the different businesses in
order to realize value from a diversified strategy.

CORPORATE DEVELOPMENT: BUILDING

AND RESTRUCTURING THE CORPORATION

Corporate Development is concerned with identifying which business

opportunities a company should pursue, how it should pursue those
opportunities and how it should exit from the business that do not fit the
company’s strategic vision.

Reviewing the Corporate Portfolio

Reviewing corporate portfolio helps to identify which business the company

should continue to participate in, which it should exit from and whether the
company should consider entering any new business areas. There are two
main approaches:

 The portfolio planning matrices – This is where there is a competitive

comparison of different businesses within the portfolio against each
other on the basis of common criteria. Portfolio planning entails:
d. Dividing the company into strategic business units (Product market)
1 - 31 -

e. Accessing the prospects of each SBU and compare them against each
other by means of a matrix. The assessing is done on two basis:

(3) Each SBU relative market share and this is the ratio of an SBU’s market
share to the market share held by the largest rival company in the
industry.

(4) The growth of the SBU’s industry. The matrix is divided into four cells:
 Stars - The leading SBU’s in a company’s portfolio are the stars

 Question marks – These are SBU’s that are relatively weak in competitive
terms (they have low relative market share) but are based in high growth
industries and thus are considered opportunities. These can become stars
if nurtured properly.

 Cash Cows – SBU.s that have high market share in low growth industry
and a strong competitive position in mature industry.

 Dogs – These are SBU’s that are in low growth industry and have a low
market share.

f. Develop strategic objectives for each SBU.

(5) The cash surplus from any cash cows should be used to support the
development of selected question marks and nurture stars.
(6) Question Marks that are weakest and most uncertain should be divested
to reduce demands on company’s cash resources.
(7) Exit SBU’s that are dogs.
(8) If the company lacks enough stars, cash cows and question marks then it
should consider acquisition or divestments to have a balanced portfolio.

Limitations of Portfolio Planning

 The model is simplistic

 The connection between relative market share and cost savings is not as
straightforward.
 A high market share in a low growth industry does not necessarily result
in the large positive cash flow.
1 - 32 -

 It does not take industry size, growth, cyclicality, competitive industry

and technical dynamism.

Chapter 7

CORPORATE DIVERSIFICATION

What is Corporate Diversification

A firm implements a corporate diversification strategy when it operates in

multiple industries or markets simultaneously.

 A firm is pursuing a product diversification product when it operates

in multiple industries simultaneously.

 When a firm operates in multiple geographic markets simultaneously,

it is said to be implementing a geographic market diversification.

 When a firm implements both types of diversification simultaneously,

it is said to be implementing a product market diversification.
1 - 33 -

Types Corporate Diversification

There are three main types of diversification, these are:

 Limited Corporate Diversification – A firm has implementing a

strategy of Limited Corporate Diversification when all of or most of
its business activities fall within a single industry and geographic
market. Two types of firms are included in this corporate
diversification category

a. Single Business Firms – These are firms with greater than 95% of
their total sales is in a single product market

b. Dominant Business Firms – These are firms with between 70% and
95% of their total sales in a single product market.

 Related Corporate Diversification – A firm is engaged in Related

Corporate Diversification when less than 70% of a firms revenue
comes from a single product market and these multiple lines of
business are linked. The multiple business that a diversified firm
pursue can be related in two ways:

a. Related Constrained – This is where, if all the business in which a firm

operates share a significant number of inputs, production
technologies, distribution channels and similar customers. Example
PepsiCo, although Pepsi operates in multiple business around the world,
all its businesses focus on snack type products, either food or
beverages.

b. Related Linked – Related Link exist if the different businesses that a

single firm pursues are linked on only a couple of dimensions.

 Unrelated Corporate Diversification - This is where a firm pursues

numerous different businesses and there are no linkages among them.

The Value of Corporate Diversification

1 - 34 -

For corporation diversification to be economically valuable, to condition

must hold.
These are:

 First there must be some valuable economy of scope among multiple

businesses in which a firm is operating.

 Second it must be less costly for managers in a firm to realize these

economies of scope than for outside equity holders on their own.

What are Valuable Economics of Scope?

Economics of scope exist in a firm when the value of the products or

services it sells increases as a function of the number of businesses in which
a firm operates. Economies of scope are valuable to the extent that they
increase a firm’s revenue or decrease its costs, compared to what would be
the case if these economies of scope were not exploited. There are
different types of economies of scope these are:

 Operational Economies of Scope

a. Shared Activities – The value chain analysis can be used to describe

business activities that may be shared across several different
businesses within diversified firms.

b. Core competencies – is defined as the collective learning in the

organization, especially how to coordinate diverse production skills and
integrate multiple streams of technologies.

 Financial Economies of Scope

a. Internal Capital Allocation - Capital can allocated to business in one

of two ways. First, business operating as independent entities can
compete for capital in external capital market.
1 - 35 -

b. Risk Reduction - The riskiness of the cash flows of diversified firms

is lower than the riskiness of the cash flows of undiversified firms.
(All the business will not be doing badly at the same time.

c. Tax Advantages -

 Anti-competitive Economies of Scope

a. Multipoint competition – Multipoint competition exists when two or

more diversified firms simultaneously compete in multiple markets.
Example HP and Dell compete in both the personal computer market
and the market for computer printers.

b. Exploiting Market Power – International allocation of capital among a

diversified firm’s businesses may enable in some of the businesses the
market power advantages it enjoys in other of its business.

 Employee and Stakeholders Incentive for Diversification

a. maximizing management compensation

Corporate Diversification and Sustained Competitive Advantage

In order for diversification to be a source of competitive advantage it must

not only be valuable, but also rare and costly to imitate and a firm must be
organized to implement this strategy.

 Rarity of Diversification – The rarity of diversification depends not on

diversification per se but on how rare the particular economies of
scope associated with that diversification are. If only few competing
firms have exploited a particular economy of scope, that economy of
scope can be rare. If numerous firms have done so, it would be
common and not a source of competitive advantage.

 The Inability of Diversification – both forms of imitation, direct

duplication and substitution are relevant in evaluating the ability of
1 - 36 -

diversification strategies to generate sustained competitive

advantage, even if the economy of scope that they generate is rare.

Chapter 8

ORGANIZING TO IMPLEMENT CORPORATE DIVERSIFICATION

Organizational Structure and Implementing Corporate diversification

The most common organizational structure for implementing corporate

diversification strategy is the Multidivisional structure (M-form). In the
multiple divisional structures each firm is managed through a division. (See
organizational chart on page 222).

The M –form structure is designed to create checks and balances for

managers that increase the probability that a diversified firm will be
managed in ways consistent with the interest of the equity holders.

The Board of Directors

One of the major components of an M-form organization is a firm’s Board of

Directors. In principle, all the firm’s senior managers reported to the
Board. A Board of Directors typically consist of 10-15 individuals drawn from
individual outside the firm.

The firm’s Senior Executives such as the CEO, CFO are usually on the board.
The Board of directors are typically organized into several committees such
as:
 Audit Committee
 Finance Committee
1 - 37 -

 Nominating Committee
 Personal and Compensation Committee

Institutional Owners

Institutional Owners are can be a single investor or it can be small blocks of

millions of investors.

Institutional owners usually include:

 Pension Funds
 Mutual funds
 Insurance Companies
 Other group of individual investors who joined together to manage
their portfolio.

The Senior Executives

The Senior Executives are responsible for the following:

 Strategy Formulation – Strategy formulation entails deciding which
set of businesses a diversified firm will operate in.
 Strategy Implementation – Strategy implementation focuses on
encouraging behaviour in a firm that is consistent with this strategy.

Corporate Staff

The primary responsibility of Corporate Staff is to provide information

about the firms’ external and internal environment to the senior executives.
This information is vital for both the strategy formulation and
implementation.

Divisional General Manager

1 - 38 -

Divisional General Manager in a Multidivisional Firm has primary

responsibilities for managing the firms business from day to day. Divisional
General Managers have full profit-and- loss responsibility and typically have
multiple functional managers reporting to them.

Shared Activity Manager

Shared activities managers create economy of scope when one or more of

the stages in their value chain are managed in common. Eg two or more
division in a multidivisional firm including common sales forces, common
distribution system, common manufacturing facilities and common research
and development effort share the same manager. The primary responsibility
of the individual who manage the shared activities is to support the
operation of the division that share the activity. This include

 Shared Activity and Cost centre – Shared Activities are often

managed as cost centres in an M-form structure, ie rather than having
profit an loss responsibility, cost centre are assigned a budget and
manage their operation to that budget.
 Shared Activity and Profit Centre – Some diversified firms are
beginning to manage shared activities as profit centres rather than
cost centres. Rather than requiring division to use the services of
shared activities, instead the division have to purchase the services
of internal shared activities.

Management Controls and Implementing Corporate Diversification

The most important management controls structure includes:

1 - 39 -

 Evaluating Divisional Performance – This is done in terms of the

division profitability or if the division is making a loss. The questions
are (1) how should division profitability be measured? (2) How should
economy of scope linkages between divisions be factored into
divisional performance measures? The measures used to measure
performance are:
a. Accounting Measures and Divisional Performance
b. Economic Measures and Divisional Performance (EVA)

 Allocating Corporate Capital – Budgeting with special emphasis on Zero

Based Budgeting. This is where corporate executive create a list of all
capital allocation request from all divisions in the firm, then rank them
from most important to least important and then allocate the funds
accordingly.

 Transferring Intermediate Products – Intermediate products or

services are those product or services produced in one division are
used as input for products produced in a second division. This is
usually managed through a transfer pricing system. This is where
one division “sells” the intermediate product or services to the second
department at a transfer price.
1 - 40 -