Reasons for the Increased Diversification by Business Firms

Growth through mergers and diversification represents a very good alternative to be taken into account in business planning. The external growth contributes to opportunities for effective alignment to the firm’s changing environments. The primary reason for acquiring or merging with another business is to produce improved cash flow or to reduce the risk faster or at a lower cost than achieving the same goal internally. Thus, the goal of any acquisition is to create a strategic advantage by paying a price for the target that is lower than the total resources required for internal development of a similar strategic position.

Another reason is the expectation on the part of the diversifying or acquiring firm that it has or will have excess capacity of general managerial capabilities in relation to its existing product market activities. Moreover, there is an expectation that in the process of interacting with the generic management activities, the diversifying firms will develop industry specific managerial experience and firm specific organization capital overtime.

Four factors have contributed to the increased diversification by business firms:

1. Advances in Managerial Technology

Important changes in the management technology include issues like development in theory and practice of planning, increased role of management functions in the firm’s operations, the development and use of formalized decision models, increased recognition of quality and continuity of the firm’s management organization as an important economic variable etc. These factors have made it beneficial to spread these abilities over a greater number of activities. Conversely, these management capabilities are not evenly distributed throughout industries giving an opportunity for firms to extend their capabilities to other firms and to new areas in order to increase the returns on investments in both management and physical assets.

2. Increased Technological Change

The opportunities for diversification have increased along with the demands to change. The expertise of technology is spread unequally among various business firms and industries. The prospects of economic profits from the supply of advanced technological capabilities to industries and firms which need them provide an increased incentive to diversify.

3. Large Fixed Costs and Staff Services

Fixed cost of business firms have increased due to the need to maintain an effective competitive position in the world economy and the resultant larger management capabilities. Investments in managerial organizations have always resulted in economies of scale rather than investment in physical assets. Hence, the economies derived from spreading the fixed costs for managerial staff functions over a wide range of activities have increased.

Credit: Strategic Management-MGU

4. Development of Equity Markets

The trends in the equity markets have strengthened the influence of the above mentioned factors in encouraging diversification by external diversification. In the equity markets stock which had a potential for growth in earnings and dividends, were highly valued. Hence, growth stocks had higher P/E ratio. This increased interest in the growth stimulated mergers in various ways. The search for product markets with growth opportunities intensified.

In a rapidly changing world, companies are facing unprecedented turmoil in global markets. Severe competition, rapid technological change, and rising stock market volatility have increased the burden on managers to deliver superior performance and value for their shareholders.

In response to these pressures, an increasing number of companies around the world are dramatically restructuring their assets, operations, and contractual relationships with shareholders, creditors, and other financial stakeholders. Corporate restructuring has facilitated thousands of organizations to re-establish their competitive advantage and respond more quickly and effectively to new opportunities and unexpected challenges. Corporate restructuring has had an equally profound impact on the many more thousands of suppliers, customers, and competitors that do business with restructured firms.

Generally, most of the corporate growth occurs by internal expansion, when a firm’s existing divisions grow through normal capital budgeting activities, nevertheless  if the goals are easily achieved within the firm, it may mean that the goals are too small. Growth opportunities come in a variety of other forms and a great deal of energy and resources may be wasted if an entrepreneur does not wait long enough to identify the various dynamics which are already in place. The most remarkable examples of growth and often the largest increases in stock prices are a result of mergers and acquisitions. M&As offer tremendous opportunities for companies to grow and add value to shareholders wealth. M&As is a strategy for growth and expansion. M&As are expected to increase value and efficiency and thereby increase shareholders value. M&As is a generic term used to represent different types of corporate restructuring exercises.

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