Chapter Five

Diversification,
Integration and
Merger

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 Introduction
• Diversification is a common practice in
manufacturing and other types of businesses
• The traditional assumption of a single
homogeneous product for the firm has no
validity in the present situation of industries
where firms are producing varieties of products,
some of which are found quite different or
unrelated to another
• Similarly, the other two activities, integration
and merger, are also quite popular in practice
• The meaning of these concepts and motives for
such activities are issues that we intend to
examine in this chapter
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 Diversification
• The typical unit of analysis in microeconomic theory
is a single–product, single–plant firm serving a
single market
• In practice, however, many firms produce a range of
products and serve a number of markets
• Such companies are described as diversified
• Diversification occurs when a single–product firm
changes itself into a multi–product or multi–market
firm
• It involves starting or acquiring new activities either
related or unrelated to the firm’s existing activities
• It can also be widened to include selling existing
products in new, geographically distinct markets
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 Types of Diversification Strategies
• The strategies of diversification can include:
– Internal development of new products or markets
– Acquisition of a firm
– Alliance with a complementary company
– Licensing of new technologies
– Distributing or importing a product line
manufactured by another firm
– Combining two or more of these options
• This combination is a function of available
opportunities and consistency with the objectives
and the resources of the company
• There are three types of diversification: concentric,
horizontal and conglomerate
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 …...Continued
Concentric diversification: A type of
diversification in which a company acquires or
develops new products (closely related to its core
business or technology) to enter one or more new
markets
• Adding new, but related, products or services is
widely called concentric diversification
• The corporation's lines of business still possess some
"common thread" that serves to relate them in some
manner
• The point of commonality may be similar
technology, customer usage, distribution,
managerial skills, or product similarity
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 …...Continued
• In other words, concentric diversification occurs
when the diversification is in some way related to,
but clearly differentiated from, the organization's
current business
• A concentric diversification strategy can have several
advantages
• The most obvious advantage is that it allows the
organization to build on its expertise in a related area
• A related diversification strategy involves
diversifying into businesses that possess some kind
of "strategic fit"
• Strategic fit exists when different businesses have
sufficiently related activity–cost chains that there are
important opportunities for activity sharing in one
business or another
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 …...Continued
• A diversified firm that exploits these activity–cost
chain interrelationships and captures the benefits of
strategic fit achieves a consolidated performance
greater than the sum of what the businesses can earn
pursuing independent strategies
• In other words, this strategy tends to increase the
firm's dependence on certain market segments
• For example, a company which was making
notebooks earlier now is also entering into pen
market through its new product
• This effect which can produce a combined return on
the firm's resources greater than the sum of its part
is frequently referred to as synergy (2 + 2 = 5 effect)
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 …...Continued
Horizontal diversification: The Company adds new
products or services that are technologically or
commercially unrelated to current products, but which
may appeal to current customers
• In a competitive environment, this form of
diversification is desirable if the present customers are
loyal to the current products and if the new products
have a good quality and are well promoted and priced
• Moreover, the new products are marketed to the same
economic environment as the existing products, which
may lead to rigidity

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 …...Continued
Conglomerate diversification also known as
lateral diversification: the company markets
new products or services that have no technological
or commercial synergies with current products, but
which may appeal to new groups of customers
• The conglomerate diversification has very little
relationship with the firm's current business
• Therefore, the main reasons of adopting such a
strategy are first to improve the profitability and the
flexibility of the company, and second to get a better
reception in capital markets as the company gets
bigger
• Even if this strategy is very risky, it could also, if
successful, provide increased growth and
profitability 9
 Motives for Diversification
• The starting point for diversification may occur
when a firm’s existing objectives vis-à-vis profit and
growth cannot be met by its existing product
• Thus, the threat to profitability is the spur/urge to
considering a diversification strategy
• However, the adoption of a diversification strategy
may be driven by a number of push factors arising
from the current position of the firm
• Push factors may include: the limited size of the
existing market; the existence of underutilized assets
that might be used to produce new products;
underutilized management to manage new activities;
and surplus investment resources that could be used
to finance new activities
• There may also be a number of pull factors, or
incentives, for firms to adopt diversification
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 …...Continued
• Managers may also be pulled toward diversification
where the potential rewards from investing in new
market opportunities promise greater profitability than
plowing them back into existing activities
• The greater the profit potential of new activities
compared with its existing activity, the stronger the pull
• However, any diversification will have a higher degree of
uncertainty attached compared with the more certain
but limited returns in existing activity
• Therefore, diversification may be a high–risk strategy
because it involves new products, new markets and the
commitment of financial and managerial resources for
uncertain returns
• The pursuit of diversification may be tempered by the
need to make sufficient profits to keep shareholders
happy and to maintain the valuation ratio of the firm
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 …...Continued
• If this cannot be achieved, then shareholders may prefer
to see retained earnings returned in the form of
dividends
• A poor stock market performance may threaten the
incumbency of the existing management, either as the
result of shareholder dissatisfaction or by outside
interests buying assets they consider to be undervalued
• Therefore, managers must also consider the threats and
risks posed to the firm as a consequence of
diversification
• The following are some of the motives of diversification
i) Utilization of the firm’s resources efficiently
• Making better use of the firm’s existing assets and
competences could lower unit costs and increase labor
and capital productivity 12
 …...Continued
• Greater use could be made of:
– Indivisible plant and equipment by making new
products alongside existing ones
– The distribution and logistics system by distributing
related goods to the same outlets/channels
– The marketing department to advertise and promote
the new product using its accumulated knowledge and
expertise of particular markets and customers
– The brand name to sell new products using the
goodwill built up for its existing branded products
– Retained earnings that are not required to develop
current activities can be used for investment in new
activities rather than keeping them in the non-interest
earning form of cash
– Managerial talent, in general and specific functions of
the firm to extend its range of activities
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 …...Continued
• An important advantage of the diversified firm is
that its corporate headquarters may have better
access to information than that available to the
market
ii) Economies of scope and size
• Economies of scope arise from the nature of the
production function, so that two or more products or
activities can be produced more cheaply together
than separately
• These benefits are not available to single–product
firms
• The increase in size of the firm that comes with
diversification may also produce economies of size
• Size may allow the company to achieve lower
management costs through organizational efficiency
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 …...Continued
• Diversification may be a spur to a firm adopting more
cost–effective organizational forms
• This structure allows the firm to add new activities
and new divisions with limited disruption to existing
activities
• If synergy gains are either non–existent or very
difficult to achieve in practice, a particular product
from a diversified firm may have no advantages over
the same product produced by a single–product,
free–standing or specialist enterprise
iii) Reducing the volatility of profits and
spreading risk
• A single–product, single–market firm is vulnerable to
erratic and cyclical variations in demand and input
costs, as well as to long–term decline in demand
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 …...Continued
• Together, these two factors lead to cyclically fluctuating
revenue and costs and hence profits
• Therefore, diversification is a way for the firm to reduce
the dispersion and offset the decline in profits
• Cyclical variations can be offset by the acquisition of
products whose sales move counter–cyclically to its
existing product
• Such diversification strategies are intended to both
stabilize and prevent the firm from making losses,
because such diversification may be a strategy designed
to avoid bankruptcy and the death of the enterprise
• Diversification enables a firm to spread risks by offering
a degree of insurance against unexpected changes in any
one market for any one product
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 …...Continued
• A market shock affecting a single product will have
greater impact on a specialist firm’s profits than
those of a diversified one
• A diversified company with a portfolio of two
products whose sales move counter–cyclically can
achieve a more even flow of revenues
iv) Financial synergies
• Diversification may limit profit variability and,
hence, variations in dividend payments to
shareholders
• This may give the firm a cost of capital advantage
compared with firms whose profits are more variable
• The diversified firm may raise new equity capital and
loans on advantageous terms that are unavailable to
firms with greater profit variability
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 …...Continued
• If the firm has a choice between equity and debt finance,
then a more stable profit and dividend flow will allow the
firm to increase the proportion of its finance raised
through debt capital
• The greater stability of earnings reduces the risk to debt
holders
• Debt capital may also offer tax advantages to the firm,
since the interest payments are treated as a cost rather
than an element of profit
• Dividends, in contrast, are regarded as profits
distributed to shareholders
• Thus, if the firm wanted to raise an equal amount of
capital using debt or equity, the level of corporation tax
payable would be higher if the equity route was chosen
• The risk of no–dividend payment to shareholders is also
reduced through debt capital financing
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 …...Continued
v) Managerial risks and rewards
• The senior managers of a company, unlike their
shareholders, cannot diversify their employment
risks
• If the firm does badly, then they face being
dismissed by shareholders or the company being
acquired by another enterprise
• As a result, it is in the interest of senior managers to
diversify the activities of the firm to reduce the
variability of overall profits, dividends, and hence,
share price to reduce the risk of their own dismissal
vi) The pursuit of growth
• Diversification may be pursued as part of the growth
strategy of the firm
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 …...Continued
• Diversification does not only reduce risks but may also
be a route to securing the growth of assets, sales and
profits
• Firms whose major objective is growth will wish to
escape from the constraints of their existing slow–
growing markets
vii) Market power
• The ability to influence the market comes partly from the
strength of the company to finance its activity in one
market with a support of profits made in another
• The implication is that diversified firms will thrive at the
expense of non–diversified firms not because they are
more efficient, but because they have access to what is
termed conglomerate power, which is derived from the
sum of its market power in individual markets 20
Vertical Integration and Vertical Restrictions
• A firm that participates in more than one successive
stage of the production or distribution of goods or
services is vertically integrated
• It is a type of diversification but it may be looked as
‘vertical concentration’, and if the process takes place by
merging of two different firms then it is ‘vertical merger’
• However, vertical integration is a popular term for all of
these activities
• Vertical integration may be initiated either when: a firm
starts manufacturing all of the intermediate products
for itself or different firms producing those intermediate
goods at different stages of the production process merge
together
• A non–integrated firm may write long term
binding/compulsory contracts with the firms with which
it deals, in which it specifies price and other terms
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 …...Continued
• Such contractual restraints are called vertical
restrictions
• For example, manufacturers commonly restrict their
distributors by determining their sales territories, setting
inventory requirements, and where it is legal, setting the
minimum retail price they can charge
• Some firms choose to vertically integrate and perform all
production and distribution activities themselves
• Others may partially vertically integrate
• For example, they may produce all intermediates
themselves but rely on others to market the products
• Some firms are not vertically integrated, but buy from a
number of suppliers or sell through a number of
distributors
• Any firm that engages in successive steps in its
production process is at least partially integrated
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 …...Continued
• Thus, most firms are at least partially integrated
• A decision by a firm to integrate vertically alters both the
boundaries and the size of the firm
• The production of goods and services involves a chain of
linked activities from raw materials to final product
• At each point the product of the previous stage is used as
input for the next stage of production
• Ultimately, all the various inputs are combined to meet
the demands of final consumers
• Vertical integration is the outcome of a make or buy
decision
• If the firm decides to make its own inputs, then it
becomes vertically integrated
• If it does not, then it remains vertically unintegrated
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 The reasons for vertical Integration
• Most of the reasons that firms choose to vertically
integrate have to do with reducing costs or
eliminating a market externality
• In general, a firm needs a good reason to vertically
integrate because integration can involve difficulty
and substantial costs of management
1. Integration to lower Transaction costs
• A firm may lower its transaction costs by vertically
integrating
• For example, the transaction costs of buying from or
selling to other companies are avoided
2. Integration to assure supply
• A firm may vertically integrate to assure itself a
steady supply of a key input
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 …...Continued
• To do so, the firm may vertically integrate backwards
buying or building the capacity to produce that input
• Delivery problems may thus be reduced, because it is
often easier to exchange information within a firm
than between firms
3. Integration to Eliminate Externalities
• A firm may vertically integrate to correct market
failures due to externalities by internalizing those
externalities
4. Integration to avoid government
intervention
• A firm may be able to avoid government restrictions,
regulations, and taxes by vertically integrating
• For instance, a vertically integrating firm can avoid
price controls by selling to itself 25
 …...Continued
5. Integration to increase Monopoly profits
• A firm may vertically integrate to increase or create
market power
• A firm may be able to increase its monopoly profits by
vertically integrating in two ways
• First, a firm that is a monopoly supplier of a key input in
a production process used by a competitive industry may
be able to vertically integrate forward, monopolize the
production industry, and increase its profits
• Or a firm that is a buyer of the key input supplier may
benefit from acquiring its sole supplier
• Second, a vertically integrated monopoly supplier may
be able to price discriminate, eliminate competition, or
foreclose entry
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 Merger and Takeover
• A company intending to acquire another company may
buy the assets or may combine with the latter
• Thus, acquisition of an organization is accomplished
either through the process of merger or through the
takeover route
• In a general sense, mergers and takeovers (or sometimes
referred to as acquisitions) are very similar corporate
actions
• They combine two previously separate firms into a single
legal entity
• Significant operational advantages can be obtained when
two firms are combined and, in fact, the goal of most
mergers and acquisitions is to improve company
performance and shareholder value over the long–term
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 …...Continued
• The motivation to pursue a merger or acquisition can be
considerable; a company that combines itself with
another can experience boosted economies of scale,
greater sales revenue and market share in its market,
broadened diversification, and increased tax efficiency
• Merger occurs when the merging companies have their
mutual consent
• It may also result from combination of two or more
companies into a single company where one survives
and the other loses its entity and a new company is
formed
• The survivor acquires the assets as well as liabilities of
the merged company
• As a result of merger, if one company survives and the
other loses its entity, it is a case of ‘Absorption’ 28
 …...Continued
• But if a new company comes into existence because
of merger, it is a process of ‘Amalgamation’ or
‘Consolidation’.
Forms of Merger:
1. Horizontal Merger: is one that takes place
between two firms in the same line of business
(industry)
2. Vertical Merger: takes place when firms in
successive stages of the same industry are
integrated
• Vertical merger may be backward, forward or both
• Backward merger refers moving closer to the source
of raw materials in their beginning form
• Forward merger refers to moving closer to the
ultimate customer 29
 …...Continued
3. Conglomerate Merger: is a fusion of companies
in unrelated lines of business
• The main reason for this type of merger is to seek
diversification for the surviving company
• Takeover, or acquisition, on the other hand, is
mostly characterized by the purchase of a smaller
company by a much larger one
• This combination of "unequals" can produce the
same benefits as merger, but it does not necessarily
have to be a mutual decision
• A larger company can initiate a hostile takeover of a
smaller firm, which essentially amounts to buying
the company in the face of resistance from the
smaller company's management
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 …...Continued
Motives for Merger
1. To Gain Scale:
• In competitive environment, size matters and
consolidation is often the only way to stay afloat
• The major driving force underlying mergers and
acquisitions is to merge and gain scale so as to compete
in the global market
2. To Avail Operating Economies:
• Firms are merged to derive operating economies in
terms of elimination of duplicate facilities, reduction of
cost, increased efficiency, better utilization of capacities
and adoption of latest technology
• Operating economies at the staff level can be achieved
through centralization or combination of such
departments as personnel accounting, advertising and
finance, which are common to both organizations
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 …...Continued
3. To Achieve Accelerated Growth:
• Both horizontal and vertical mergers take place to
achieve growth at higher rate than the one
accomplished through its normal process of internal
expansion
4. To Take Advantage of Complementary
Resources:
• Merger is in the vital interest of the two firms if they
have complementary resources
• The two firms are worth more together than apart
because each acquires something it does not have
and gets it cheaper than it would by acting on its
own
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 …...Continued
• Other motives for merger include:-
5. To Strengthen Controlling Power:
6. To Access New Technology:
7. To Avail Tax Benefits:
8. To Penetrate Global Markets:
9. Changes and Trends in the economy as a
whole:

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