Deck 16: Diversification Strategy

Question 1

The cost-of-entry test tries to:

A)Ensure that an acquirer does not spend more on diversifying than the estimated future cashflows are worth
B)Assess the cost of entry for other firms if the focal firm is already in the industry
C)Determine which revenues would be generated by the entry
D)None of the above

Answer 1

A

Question 2

Why is diversification such an important component of a firm's strategy?

Answer 2

Diversification is basically about the question of "what business we are in".
It is a conundrum, because diversification can prove to be a very valuable strategy for achieving success or, conversely, for decreasing stockholder value.
The decision to diversify or not should be based on two fundamental questions:
1-How attractive is the industry in which a firm would like to enter?
2-Can a firm establish a competitive advantage in that new industry?
Therefore, a decision regarding diversification may be justified by a potential superior profit of the industry to be entered, or by the ability of a firm to create a competitive advantage, which largely relies on the fit between the industry environment and a firm's resources and competencies.
To determine if diversification would create shareholder value, Porter proposes three tests:
a) the attractiveness test, where the new industry must be attractive (level of competition, growth, profit, etc.)
b) the cost-of-entry test, which assesses the cost for entry, taking into consideration the barriers to entry
c) the better-off test, which evaluates the extent to which the entry into a new industry will benefit existing businesses, and the extent to which the new business will benefit from a firm's existing businesses. In other words, each one must benefit from the other, and the addition of that new business must generate synergies within the firm.

Question 3

What does diversification over time show us?

Answer 3

Over time, the "diversification pendulum" has swung away from intensive diversification to a trend toward concentration, and greatly reduced levels of diversification.
The diversification era took place approximately between 1950 and 1980, when it was an important source of corporate growth. A new corporate form, the conglomerate, emerged in the 1970s, through multiple and unrelated acquisitions. A common idea among managers was to not consider industry specific knowledge as critical for the success of a diversified firm, because techniques of financial and strategic management would compensate for the absence of such knowledge and experience.
After 1980, the trend reversed and diversification decreased, due mainly to three factors:
a) a shift in corporate goals from growth to profitability
b) inefficiencies of corporate management, within a conglomerate, during turbulent economic times
c) the emergence of new strategic thinking about the conditions under which unrelated diversification may be profitable and desirable, and the development of new approaches based on the construction of competitive advantages derived from a firm's resources and capabilities
This evolution demonstrates the power of the "general thinking" in the managerial field, the variations of positions firms take in regard to diversification across geographies and time, and the fact that most firms in fact "test" managerial practices, and then use the result as a lesson to change them. No one really knows in advance which managerial practice is going to be successful.

Question 4

Which of these three tests dominate in most circumstances?

A)The attractiveness test
B)The cost-of-entry test
C)The better-off test
D)None of them.

Question 5

Regarding tangible and intangible resources:

A)Both can be sources of economies of scope
B)Only tangible resources offer economies of scope;
C)Only intangible resources offer economies of scope
D)Both are sources of economies of scope, but not simultaneously

Question 6

Is it correct to claim that diversification provides a benefit of "risk spreading"?

A)Yes, in most cases, but it's of little interest or value to shareholders, since they can do that more easily and cheaply themselves
B)No, usually that is not the case
C)The answer is not that simplistic
D)Risk spreading is not always a benefit

Question 7

The better-off test addresses:

A)The extent of the potential retaliation from incumbents
B)The effect of the combination of the R&D activities together
C)The effect of the combination of the production activities together
D)The potential for several businesses managed as one to be more profitable than if they continued to be operated separately

Question 8

How can related vs. unrelated diversification be identified?

Question 9

Is it possible to benefit from economies of scope and economies of scale simultaneously?

A)Yes, although in practice one is likely to be more important than the other in a specific firm
B)Theoretically yes, but the organization would need to be larger than any in existence today
C)Yes, but you have to achieve one first, then the other
D)No. They are mutually exclusive

Question 10

Pharmaceuticals, corporate legal services, and defense contracting are industries:

A)That always provide above-average returns
B)Requiring sophisticated scientific knowledge
C)Protected by barriers to entry
D)Protected by barriers to exit

Question 11

The primary source of creating competitive advantage from diversification is to:

A)Share resources and capabilities across businesses
B)Share resources across related businesses only
C)Erect strong barriers to entry around each business
D)Be able to strongly retaliate against any rival's attack

Question 12

RJR Nabisco was taken over in 1989 for $31bn by:

A)The Blackstone Group
B)Kohlberg Kravis Roberts
C)The Carlyle Group
D)CVC Capital Partners

Question 13

Porter's three tests help to determine:

A)What the level of risk is for a potential diversification
B)Whether diversification would create shareholders' value
C)If top managers will benefit from diversification
D)How the financial markets would react to a diversification

Question 14

Economies of scale and economies of scope are:

A)The same concepts
B)Similar concepts, except that economies of scope relate to expansion across multiple products
C)Similar concepts whose distinction is only really understood by economists
D)Concepts borrowed from different disciplines

Question 15

By leasing out space to specialist retailers and restaurants, airport and railroad station operators:

A)Always achieve above average returns
B)Exploit their leaning curves
C)Exploit economies of scope of their facilities
D)Employ their assets to generate little value

Question 16

Which firms in low-growth and cash-flow rich industries could have been tempted by diversification?

A)Mittal Steel
B)3M
C)Oil and tobacco firms
D)Microsoft

Question 17

Does a firm need to diversify across different businesses in order to benefit from economies of scope?

Question 18

Does diversification confer market power?

Question 19

ITT, Textron, General Electric, and Allied Signal in the US, and Hanson, Slater-Walker, and BTR in the UK are:

A)Conglomerates in related businesses
B)Conglomerates
C)Vertically integrated firms
D)Large and unsuccessful firms

Question 20

Are there examples of profitable unrelated diversified firms?

Question 21

Research shows that firms with exceptional performance are characterized by:

A)Strict financial discipline
B)Rigorous analysis and valuation
C)A willingness to close or sell existing businesses
D)All of the above

Question 22

Canon, General Electric, Unilever, and Nestle are examples of firms:

A)That are not successful
B)For which graduating students are intensively competing, because of their reputation for developing recruits for their diverse businesses
C)That do not transfer their employees between divisions
D)For which public opinion is generally negative

Question 23

What are the key characteristics of "private equity firms"?

A)They raise funds to buy the entire equity in businesses, remove them from the stock market, and sell them at a later date
B)They buy and resell businesses immediately
C)They have very aggressive business behaviors
D)They do not take into consideration their businesses' human resources

Question 24

The distinction between the respective definitions of related and unrelated businesses:

A)Is always clear
B)Is extremely confusing
C)Is somewhat unclear, and is a matter of context and judgment
D)Is a moot point

Question 25

Where do general management capabilities generally reside?

A)At the corporate level
B)At the divisional level
C)At the operational entity level
D)All of the above

Question 26

Which is the most efficient: the internal market of diversified firms or the external capital market?

A)It depends on the effectiveness of the specific firm's capital allocation process and team.
B)The internal market
C)The external market
D)It remains an unresolved matter requiring more research

Question 27

When trying to link performance to diversification:

A)It is not easy to distinguish association from causation in the results
B)It is difficult to source reliable data
C)It's difficult to distinguish between permanent and temporary phenomena
D)Statistical tools are generally inadequate to determine the true position

Question 28

Can economies of scope exist in a very small business?

A)No. Only large businesses can be sufficiently large to accrue such benefits
B)Yes. For example, a village shop which is also a post-office
C)It is unlikely that the managers of such a small business would understand the theory enough to apply it
D)Theoretically yes, but they are very rare

Question 29

What is the alternative to Porter's better-off test?

A)The acid test
B)The attractiveness test
C)The parenting value added test
D)The diamond test

Question 30

When a diversified firm concentrates on its core businesses, the market typically values its stock higher. What could one infer from this?

A)Stockholders should sell their stocks
B)Diversified firms cannot be profitable
C)The market believes that those parts of the diversified firm sold off were being managed so badly they were reducing long term profit prospects
D)Growing economic turbulence has increased the cost of managing diversified firms

Question 31

General management capabilities should be considered as:

A)Organizational resources
B)Competitive resources
C)Distinctive competencies
D)Organizational capabilities

Question 32

Diversification into related industries is more likely to be profitable than diversification in unrelated industries:

A)Is a generally true statement
B)Is a false statement
C)Has never been tested
D)Is not supported by empirical evidence

Question 33

What are "shared service organizations"?

A)Organizational entities providing administrative and technical services to diverse businesses
B)Organizational entities shared between different independent firms
C)Governmental agencies that provide services to small businesses and start-ups
D)Professional service firms such as accountants

Question 34

The text claims that economies of scope must be supported by potential transaction cost savings:

A)This is true. The firm itself must be able to save on transaction costs
B)This is true - however, the saving could be on behalf of the firms' customers. This would work too.
C)This is not quite true. Transaction cost savings are nice to have, but not necessary
D)This is untrue. The text is mistaken.

Question 35

What are "strategic-level linkages" when discussing diversification?

A)The ability to use very different marketing strategies that fit with different countries
B)The ability to sell similar products
C)The ability to apply similar strategies, resource allocation procedures, and control systems across the businesses
D)The ability to maximize the allocation of financial resources across the businesses

Question 36

Several decades of empirical evidence indicates that the relationship between diversification and performance:

A)Still appears mixed
B)Has been proved as fully positive
C)Is not consistent nor is it systematic
D)Still does not make sense

Question 37

The internal labor market provides a large, diverse firm with the chance to make savings, by:

A)Developing senior managers with wide experience
B)Relying less on external recruitment consultants
C)Having first-hand knowledge of a large pool of internal recruits for transfer between businesses
D)All the above

Question 38

Bringing different businesses under a single ownership in theory:

A)Creates value for shareholders
B)Does not create value for shareholders, by itself
C)Has negative impact on the creation of shareholders' value, by itself
D)Creates value for shareholders if the cash flows of the businesses are not correlated

Question 39

Diversified firms exhibit two key advantages but only one disadvantage regarding internal capital allocation:

A)Therefore, on balance, internal capital markets are
Preferable
B)This isn't the whole story. Other major
Disadvantages swing the balance the other way
C)It's not the number of disadvantages, but the
Overall balance which matters
D)Political processes always outweigh the
Advantages

Question 40

The growth objective can be negative for a firm. Why?

A)A mature market could lead managers to invest profits in diversifying, rather than return the value to shareholders to invest elsewhere themselves
B)Top managers may have an incentive to grow the firm at the expense of long-term profits and shareholder interests
C)Even without diversification, sales maximisation does not usually lead to profit maximisation
D)All of the above

Question 41

Large diversified companies are very good at:

A)Reacting quickly to market downturns
B)Downsizing and refocusing
C)Carrying out routine processes they've had time to get right
D)Running diversified portfolios

Question 42

There was a surge in "leveraged buyouts" in the 1980s. This means:

A)That buyers used legal action and other means to "leverage out" poor CEOs
B)That acquirers bought firms, and let it be known in advance that the previous management would be "leveraged out"
C)That the acquirer used the future value of the acquisition as security to borrow the money to buy the company
D)All of the above

Question 43

CAPM stands for:

A)Compound Assessment of Portfolios and Markets
B)Capital Assessment Per Module
C)Capital Asset Pricing Model
D)Capital Allocation in high Performing Markets

Question 44

Leveraged buyouts happened because:

A)The 1980s saw the birth of the corporate raider
Such as KKR
B)The time was ripe, since many conglomerates' market value was less than their break-up value
C)Shareholders were fed up with poor CEOs
D)It was the only way to get rid of underperforming corporate management

Question 45

"What business are we in?" is a question that:

A)Is the starting point of strategy
B)Is the basis for a firm's identity
C)Both a and b
D)Neither a or b

Question 46

The key to the creation of value through diversification is:

A)The relative financial powers of different diversified companies
B)The ability of the diversified company to acquire knowledge faster than market diffusion effects
C)The ability of the diversified company to benefit from economies of scope across its businesses
D)The ability of the diversified company to share resources and transfer capabilities more efficiently than the external market

Question 47

Over the past 30 years:

A)Firms have had to refocus to be profitable
B)Diversification has been unprofitable
C)The trend has been to refocus on the core business
D)All of the above

Question 48

Which of the two, the individual investor or the firm, can diversify its portfolio at the lowest cost?

A)The firm
B)The individual investor
C)There is no significant difference
D)None of the above

Question 49

CAPM theory indicates that:

A)Combining several firms under one owner may offset specific risk, but has no effect on systematic risk
B)A diversified portfolio should only be undertaken by corporate finance specialists
C)Spreading risk through diversification may benefit only stakeholders other than shareholders
D)A and c above

Question 50

Management thinking in the 1990's began to recognize that:

A)Large diversified firms were run by ineffective managers
B)In hard times, senior managers needed to focus on key capabilities, and preferably have industry-specific experience
C)Diversified firms should move to developing countries
D)All of the above

Question 51

Diversification should:

A)Be avoided
B)Be a last resort
C)Only be undertaken if it is genuinely expected to yield benefits
D)All of the above

Question 52

The emphasis of large companies in the era 1950-80 was on:

A)Spreading risk through involvement in a portfolio of businesses, often unrelated
B)Overall sales growth
C)Growth in the overall size of the firm e.g. employees, assets
D)All of the above

Question 53

Which factors influenced the "era of diversification" in 1950-80?

A)Stakeholders' greed, top managers' will, and risk reduction
B)Risk reduction and growth
C)Profitability, international competition, and stakeholders' greed
D)Opportunities, availability of resources, and luck

Question 54

What are the consequences of diversification for corporate performance?

A)It rarely creates value
B)It nearly always destroys value
C)It may create or destroy value, depending largely on how sensible it is and how well it is executed
D)None of the above

Question 55

The reversal of the trend for diversification around 1980 was probably precipitated by:

A)A realisation that CEOs had been operating in their own interests
B)High interest rates, slow real growth, and lower inflation
C)Pressure from pension funds
D)New theories on management thinking from leading academics

Question 56

After KKR acquired RJR Nabisco in 1989, large diversified firms rushed to refocus. Why?

A)The timing of this was pure coincidence
B)They hated Nabisco
C)They hated KKR
D)They feared that leveraged buyout specialists would do it to them

Question 57

When a diversified firm combines unrelated businesses:

A)Research suggests there is an absence of shareholder's benefits
B)Research indicates there is a shareholder's benefit
C)Research is inconclusive about benefits to shareholders
D)Empirical research is required in advance

Question 58

When the business environment becomes turbulent, diversified firms' senior managers:

A)Generally lack the skills to deal with the situation
B)Tend to be unable to react quickly enough through inefficient decision making structures
C)Turn on each other and play personal politics
D)Generally are so out of touch that they do not realize anything is wrong

Question 59

What does the expression "conglomerate discount" mean?

A)A firm's presence in different businesses allows a decrease in its total costs
B)Stock exchanges or bourses offered conglomerate shares at special-offer discounts
C)The stock market tends to value diversified companies at less than their break-up value
D)The stock market values moderately diversified companies at more than the sum of their parts

Question 60

Diversified firms remain popular in developing countries probably because:

A)In a fast growing economy, there are few senior managers with the skills required to run large companies well
B)They operate in a high-growth environment akin to the West in 1950-80
C)Both a and b
D)Neither a or b

Question 61

In theory, the lower risks of a balanced portfolio and the insider knowledge of subsidiaries are arguments in support of the internal capital market of a diversified firm.

Question 62

Under the Porter model, it really only matters that the combined firm is better-off than had acquirer and acquiree remained separate.

Question 63

The primary reasons for diversification during the period prior to 1980 were growth and risk reduction

Question 64

Related diversification tends to produce better results than unrelated diversification

Question 65

According to Porter, industry attractiveness is not enough to justify diversification. There needs to be additional competitive advantage, and the entry cost should not be more than the profits are worth

Question 66

In practice, internal capital markets tend to allocate funds to subsidise poor performing subsidiaries

Question 67

Diversification that reduces the risk of bankruptcy is more beneficial to managers than shareholders

Question 68

Conglomerates are:

A)Multiple related businesses under the umbrella of a single corporate parent
B)Large firms characterized by inefficiencies and large corporate staff
C)Highly diversified firms, generally created by multiple and unrelated acquisitions
D)Large firms, but with no core business

Question 69

Synergies are opportunities for competitive advantage gained from linkages between different businesses in the same firm

Question 70

A supermarket chain would be a prime example of a business whose strategy is to exploit economies of scope.

Question 71

Capabilities resting upon the complex skills of specific people or teams are exploited much better through diversification than through external contracts

Question 72

Economies of scope can also be achieved by licensing and royalties.

Question 73

Sometimes, it can even make financial sense for a firm to enter a prima facie unattractive industry

Question 74

One reason for the refocusing after 1980 was the slowdown in growth highlighting the inadequate profitability of firms whose CEOs had hitherto pursued growth as a primary objective

Question 75

Regarding diversification, two periods stand out in the last century: 1950 to 1980, when the trend was to diversify, and 1980 to today, characterized by firms refocusing on their core businesses

Question 76

Economies of scope are really just another term for economies of scale

Question 77

The decision to diversify has probably led to the destruction of more value than any other corporate decision

Question 78

A firm's business scope never changes over time

Question 79

LVMH (Louis Vuitton, Hennessy, Dior, Celine, Givenchy, Guerlain, Sephora) has justified diversification by demonstrating a corporate ability to manage luxury brands

Question 80

Some senior management teams have proven highly successful at running diversified firms, but the refocusing trend of the past 30 years suggests these are exceptional cases