Question

-Why is diversification more difficult to achieve for companies than investors?

-Under what circumstances would diversification create an economic advantage for companies considering merger?

Answer 1

Why is diversification more difficult to achieve for companies than investors?

A diversified company owns or operates in multiple unrelated business segments or industries. Examples of a diversified company are large Conglomerates such as General Electric which started as a lighting business but now also makes medical devices and household appliances. Another example of a diversified company is the Tata group which operates in Automobile, IT, FMCG and Retail industry.

Diversification involves adding new products or services that are significantly unrelated with no tehcnological or commerical similarities. Companies achieve this either through organic or inorganic growth i.e. companies may become diversified by entering into new businesses on its own or by acquiring or merging with another company. Diversification decisions often come along with risk in terms of capital investment budgeting and inheritting business operations that are not usually the strength of the acquiring company. Finances available to companies are limited and need to be appropriately apportioned to profitable projects and hence diversifying into various projects that are risky can hurt the shareholders. Acquring company, also faces competition from well established industry players, adding to the risk of diversifiying.

On the other hand, an investor only invests into the financing of the company and not often into its operations. The operations are handled by the management and board that have the technical capabilities of managing the firm. Hence mitigating the risk of operating unrelated firms. For this reason, diversification is easier to achieve by investors than companies.

Under what circumstances would diversification create an economic advantage for companianes considering merger

Following are the economic advantages for a company considering merger

Economies of scale. Defined as the cost advantages that enterprises obtain due to their scale of operation. This occurs when a larger firm is able to increase output and source raw materials in bulk, which reduces average costs of production.

Increase in Market Share.When companies merge, the new company gains a larger market share and gets ahead in the competition. Larger market share enables the entity to control the market and hence the pricing giving economic advantage.

Efficiency. Some companies producing similar products may merge to avoid duplication and eliminate competition and maximise utilization of existing underutilized resources, making them cost efficient.

Another advantage of merger is EPS bootsrapping - though this advantage does not have an economic advantage.

EPS Bootstraping. A conglomerate can grow by acquiring companies, whose shares are discounted implying underpriced, thereby showing growth in earnings.