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8 Organizing to Implement Corporate Diversification CHALLENGE QUESTIONS 8.1. Agency theory has been criticized for assuming that managers, left on their own, will behave in ways that reduce the wealth of outside equity holders when, in fact, most managers are highly responsible stewards of the assets they control. This alternative view of managers has been called stewardship theory. Why would you agree with this criticism of agency theory? It is true that egregious abuse of managerial powers (such as the case of Dennis Kozlowski of Tyco International and others) is the exception rather than the rule. Most managers align their interests with those of the stockholders. However, the point is that there is considerable potential for agency problems in the corporate world. Principals do not have the ability to monitor the activities of agents very closely. There is information asymmetry in the principal-agent relationship in that agents typically have far more information than what they share with principals. Some managers take advantage of this to further their own interests, while the majority does not. Agency theory refers to this as the “moral hazard” issue. Stewardship theory captures the role of managers as guardians or stewards of owners’ wealth. While this may be largely true in corporate America, agency problems do surface now and then. 8.2. Suppose that the concept of stewardship theory is correct and that most managers, most of the time, behave responsibly and make decisions that maximize the present value of the assets they control. What implications, if any, would this supposition have on organizing to implement diversification strategies? Implementation practices—organizational structure, managerial control systems, and compensation practices—are all aimed at preventing agency problems. In other words, the key to implementing a diversification strategy is to align the interests of owners and managers. Thus, the M-form structure specifies responsibilities and allows a group of managers to focus on their product-markets. Performance evaluation ensures adherence to organizational goals and compensation practices reward productive behavior. If an organization subscribes to the stewardship theory, then the way it would implement its diversification strategy would very likely be different. It is possible that in such an organization, managers set their own goals and there is a collaborative approach to performance measurement. The reward system also is likely to be set up in a way that managers get paid a straight salary and there are no stock-based rewards. In short, the fundamentals of implementation are very likely to be different in an organization that adheres to the stewardship theory. 8.3. The M-form structure enables firms to pursue complex corporate diversification strategies by delegating different management responsibilities to different individuals and groups within a firm. Based on the concept of the M-form structure is there a natural limit to the efficient size of a diversified firm? Imagine a firm with a hundred different products, where the product-market profile of each is distinct. In order to be effective, such a firm has to use a M-form structure with a hundred divisions. Not only would such an organization become cumbersome to manage, from the corporate office’s point-of-view, there would also be tremendous inefficiencies due to duplication of certain activities. The logical choice for such an organization would be to organize itself more along the lines of strategic business units (SBUs) rather than individual products. In the SBU approach, clusters of closely related products are grouped together as one business unit. The SBU approach recognizes that there is a natural limit to the efficient size of a diversified firm and so it uses a different approach to structuring the firm. The key is to strike the right balance between autonomy to focus on the specifics of a distinct product-market on the one hand and organizational efficiency on the other hand. 8.4. Most observers agree that centrally planned economies fail because it is impossible for bureaucrats in large government hierarchies to coordinate different sectors of an economy as efficiently as market mechanisms do. Many diversified firms, however, are as large as some economies and use private sector hierarchies to coordinate diverse business activities in a firm. Why would you consider these large, private sector hierarchies somehow different from the government hierarchies of centrally planned economies? There are two key differences between the two. One is that, on a routine basis, private sector hierarchies of companies face market realities. A major investment by a competitor in a marketing campaign may reduce the firm’s market share, lower sales, and profitability. The private sector hierarchy has to respond to this market force. This does not happen typically in governmental hierarchies. In fact, most would argue that governmental hierarchies are insulated from market forces. The second difference is the power of incentives. Reward systems are different in governmental hierarchies and private sector hierarchies. By using a combination of salary and stock-based compensation, private sector managers can be motivated to improve efficiencies in their organizations. Private sector hierarchies continue to thrive because there is an in-built system to promote efficiency, unlike the case of governmental bureaucracies. 8.5. Most observers agree that centrally planned economies fail because it is impossible for bureaucrats in large government hierarchies to coordinate different sectors of an economy as efficiently as market mechanisms do. Many diversified firms, however, are as large as some economies and use private sector hierarchies to coordinate diverse business activities in a firm. If you do not consider these large private sector hierarchies as different from the government hierarchies of centrally planned economies, then why do they continue to exist? There are similarities between government hierarchies of centrally planned economies and those of large, diversified organizations. On a regular basis, resource allocation decisions have to be made in both types and in both cases, organizational sub-units exhibit significant differences. Notwithstanding the failure associated with centrally planned economies, a similar organizational form exists in large diversified firms because it is still seen as the best way to organize such forms. 8.6. Suppose that the optimal transfer price between one business and all other business activities in a firm is the market price. What does this condition say about whether this firm should own this business? When the optimal transfer price between one business and all other business activities in a firm is the market price, it means that theoretically the receiving units can buy the product or service from the market. There is no economic logic for the firm to perform the activity in-house. For example, if one unit of an automotive firm transfers brake pads to another unit at a price of $5 each and the buying unit can procure brake pads from outside vendors for the same price, maybe the firm should not be in the business of making brake pads. The logic of economy of scope is missing in this case. Bringing this activity in-house creates an additional level of bureaucracy in the firm. It is fine if this increase in bureaucracy is more than offset by an increase in efficiency in the form of lower cost for producing a product or service. In the case of the firm making brake pads, this rationale is not present. On the other hand, if the selling division has a cost advantage over outside vendors, the firm as a whole may realize an economy of scope and gain above normal returns. Problem Set 8.7. Which elements of the M-form structure (the board of directors, the office of the CEO, corporate staff, division general managers, shared activity managers) should be involved in the following business activities? If more than one of these groups should be involved, indicate their relative level of involvement (e.g. 20% office of the CEO, 10% shared activity manager, 70% division general manager). Justify your answers. a. Determining the compensation of the CEO. b. Determining the compensation of the Corporate Vice President of Human Resources. c. Determining the compensation of a Vice President of Human Resources in a particular business division. d. Deciding to sell a business division. e. Deciding to buy a relatively small firm whose activities are closely related to the activities of one of the firm’s current division. f. Deciding to buy a larger firm that is not closely related to the activities of any of the firm’s current divisions. g. Evaluating the performance of the Vice President of Sales, a manager whose sales staff sells the products of the three divisions in the firm. h. Evaluating the performance of the Vice President of Sales, a manager whose staff sells the products of only one division in the firm. i. How much money to invest in a corporate R&D function. j. How much money to invest in an R&D function that supports the operation of two divisions within the firm. k. Whether or not to fire an R&D scientist. l. Whether or not to fire the Vice President of Accounting in a particular division. m. Whether or not to fire the corporation’s Vice President of Accounting. n. The decision to take a firm public by selling stock in the firm to the general public for the first time. 8.8. Consider the following facts: Division A in a firm has generated $847,000 of profits on $24 million worth of sales, using $32 million worth of dedicated assets. The cost of capital for this firm is 9%, and the firm has invested $7.3 million in this division. a. Calculate the ROS and ROA of Division A. If the hurdle rate for ROS and ROA in this firm are, respectively, 0.06 and 0.04, has this division performed well? b. Calculate the EVA of Division A (assuming that the reported profits have already been adjusted). Based on this EVA, has this division performed well? c. Suppose you were CEO of this firm, how would you choose between ROS/ROA and EVA for evaluating this division? 8.9. Suppose that Division A sells an intermediate product to Division B. Choose one of the ways of determining transfer prices described in the chapter (not setting transfer prices equal to the selling firm’s opportunity costs) and show how Division Manager A can use this mechanism to justify a high transfer price, while Division Manager B can use this mechanism to justify a lower transfer price. Repeat this exercise with another approach to setting transfer prices described in the chapter. Answer 8.7 M-form structure elements for scenarios described in question 8.1 above. (Note: Students will vary in terms of the degree of responsibility for each of the decision makers in the organization. Discussion on the relative weight given to each of the offices below will be useful for the instructor and students in assessing the M-Form organizational structure. a. CEO compensation – Board of Directors b. Corp. VP of HR – CEO c. VP HR in Div. – Corp VP for HR d. Sell business division – CEO and Board of Directors e. Buy small division – CEO and Board f. Buy larger firm – CEO and Board g. Performance of VP of Sales – Corp VP of Sales; recommendation to CEO h. VP of Sales in one division – Division General Manager & Corp VP of Sales i. Invest in R&D – VP of Finance, VP of Accounting, VP of R & D, and CEO j. R&D w/ two divisions – VP of R&D, Finance, Accounting, and CEO k. Terminate an R&D scientist – VP of R&D and HR l. Terminate the VP of Accounting in one division – Division GM, VP of Accounting, VP of HR m. Terminate the Corp. VP of Accounting – CEO n. Decision to take a firm public – CEO and Board of Directors Answer 8.8 a. Calculate ROA = Net Profit Margin X Asset Turn = ROA = .035 * .750 = 2.65% b. Calculate ROS = Net Income/Total Sales = 847,000/24,000,000 = .035 c. Company exceeds the threshold for ROA but not for ROS. Has the division performed well based on EVA? Answer is perhaps. A cursory look at the cost of capital (9%) yields a benchmark of 657,000 on direct investment of 7.3 million. So the expected yield would be 657,000 and the net income is 847,000. We do not know, however, the WACC and whether or not the firm is public. How to choose between ROS/ROA and EVA? Whether or not the company is leveraged, is public, etc. and what the WACC is for this firm will all be factored into the decision-making. Coca-Cola is a firm that pays very careful attention to its internal EVA. Students may want to research how decisions are made at this company based on the internal use of EVA. Answer 8.9 Students have the option of applying four different Transfer Pricing Schemes to this problem. Table 8.3 provides the four alternatives that could be applied by students. These are: Exchange autonomy – Buying and selling division general managers free to negotiate transfer price without corporate involvement; Transfer price is set equal to the selling division’s price to external customers. Mandated full cost – Transfer price is set equal to the selling division’s actual cost of production; Transfer price is set equal to the selling division’s standard cost. Mandated market based – Transfer price is set equal to the market price in the selling division’s market. Dual pricing – Transfer price for the buying division is set equal to the selling division’s actual or standard costs; Transfer price for the selling division is set equal to the price to external customers or to the market price in the selling division’s market. 9 Strategic Alliances CHALLENGE QUESTIONS 9.1. One reason why firms might want to pursue a strategic alliance strategy is to exploit economies of scale. Exploiting economies of scale should reduce a firm’s costs. Why would this mean that a firm pursuing an alliance strategy to exploit economies of scale is actually pursuing a cost leadership strategy? While the objective of a cost leader is to lower its cost structure through economies of scale, a firm pursuing a strategy of differentiation may also be interested in economies of scale. If there is a certain activity (say distribution) which is less important to the differentiator in terms of its competitive advantage, it would seek to minimize its distribution costs. In other words, for such a company, distribution is necessary but not a source of competitive advantage. Utilizing economies of scale (through an alliance) helps minimize the cost of this activity. 9.2. Consider the joint venture between General Motors and Toyota. GM has been interested in learning how to profitably manufacture high-quality small cars from its alliance with Toyota. Toyota has been interested in gaining access to GM’s U.S. distribution network and in reducing the political liability associated with local content laws. Which of these firms do you think is more likely to accomplish its objectives, and why? Toyota is more likely to achieve its objectives simply because what it is trying to learn is easier than what GM is trying to learn. Accessing GM’s U.S. network and adhering to local content laws is far easier to learn than complex manufacturing processes. GM has the bigger challenge because Toyota’s manufacturing expertise (in small cars) may consist of various tangible and intangible factors, some of which may take tremendous amounts of time to absorb. 9.3. Consider the joint venture between General Motors and Toyota. GM has been interested in learning how to profitably manufacture high-quality small cars from its alliance with Toyota. Toyota has been interested in gaining access to GM’s U.S. distribution network and in reducing the political liability associated with local content laws. What implications, if any, does your answer have for a “learning race” in this alliance? Since both companies are competitors, they are engaged in a “learning race.” Each, in a way, is motivated to slow the other down. Which aspect is easier to slow down – manufacturing techniques or distribution structure? Arguably, it is manufacturing techniques because Toyota can “choose” to keep hidden certain nuances of its production technology. Distribution is more visible and therefore may be harder to slow down. 9.4. Some researchers have argued that strategic alliances are one way in which firms can help facilitate the development of a tacit collusion strategy. In your view, what are the critical differences between tacit collusion strategies and strategic alliance strategies? As defined in the chapter, strategic alliance is a broad term that captures any kind of long-term cooperative relationship between two or more companies. For example, a firm may enter into a strategic alliance with a key supplier regarding a particular component, or with a key distributor to market the product, or with a competitor to jointly develop products. Tacit collusion occurs when two parties indirectly agree to take actions that benefit them at the cost of others. Therefore, the principal difference between the two is with regards to intentions. The alliance between the manufacturer and the distributor may be intended to help strengthen the manufacturer’s downstream activities. On the other hand, the unwritten motivation may be to prevent competitors from accessing the distributor’s infrastructure. It is the same arrangement, except that the intentions are different. 9.5 How can one tell whether two firms are engaging in an alliance to facilitate collusion or are engaging in an alliance for other purposes? Signaling is a key aspect that indicates whether two firms are engaging in an alliance to facilitate collusion or are doing it for some other purpose. When firms exchange signals via public announcements about price increases, etc., it is a clear indication about their motive. 9.6. Some researchers have argued that alliances can be used to help firms evaluate the economic potential of entering into a new industry or market. Under what conditions will a firm seeking to evaluate these opportunities, need to invest in an alliance to accomplish this evaluation? Strategic alliances are attractive from a learning perspective. By entering into a strategic alliance for, say, international market entry, the firm is evaluating the attractiveness of the new market and learning how to succeed in that new market. 9.7. Some researchers have argued that alliances can be used to help firms evaluate the economic potential of entering into a new industry or market. Why couldn’t such a firm simply hire some smart managers, consultants, and industry experts to evaluate the economic potential of entering into a new industry? Strategic alliances are attractive from a learning perspective. This learning opportunity is absent when the firm hires consultants to do the evaluation. 9.8. Some researchers have argued that alliances can be used to help firms evaluate the economic potential of entering into a new industry or market. What, if anything, about an alliance makes this a better way to evaluate entry opportunities than alternatives? A major advantage of strategic alliances in this context is that alliances are options that allow a firm to pursue future opportunities. The real options approach considers what are called “embedded” options – options embedded in certain options. An alliance agreement that allows the firm to buy out its partner is an example of a real option. This way, the firm can evaluate the market potential and if it is a very attractive market, the firm then has the option to buy out the partner. These avenues are not open when consultants are used. 9.9. If adverse selection, moral hazard, and holdup are such significant problems for firms pursuing alliance strategies, why do firms even bother with alliances? Adverse selection, moral hazard, and holdup are indeed problems that can affect the success of a strategic alliance. However, there are tremendous advantages to strategic alliances, particularly in comparison with a “go it alone” strategy. Let’s look at the example of a U.S. electronics firm considering entry into China. First of all, the firm may not have the capabilities (knowledge of market, infrastructure, etc.) to succeed in China. A partner may have these capabilities plus local contacts. Second, what if the Chinese market does not pan out? 9.10. If adverse selection, moral hazard, and holdup are such significant problems for firms pursuing alliance strategies, why don’t they instead adopt a “go it alone” strategy to replace strategic alliances? Withdrawal can be costly and time consuming if the firm had used a “go it alone” strategy. It is relatively easy when it involves a strategic alliance. The key is not to be discouraged by adverse selection, moral hazard, and holdup. Rather, it is important to do the due diligence well so that the firm can take advantage of this vehicle. Problem Set 9.11. Which of the following firms faces the greater threat of “cheating” in the alliances described, and why? (a) Firms I and II form a strategic alliance. As part of the alliance, Firm I agrees to build a new plant right next to Firm II’s primary facility. In return, Firm II promises to buy most of the output of this new plant. Who is at risk, Firm I or Firm II? (b) Firms A and B form a strategic alliance. As part of the alliance, Firm A promises to begin selling products it already sells around the world in the home country of Firm B. In return, Firm B promises to provide Firm A with crucial contracts in its home country’s government. These contracts are essential if Firm A is going to be able to sell in Firm B’s home country. Who is at risk, Firm A or Firm B? (c) Firms 1 and Firm 2 form a strategic alliance. As part of the alliance, Firm 1 promises to provide Firm 2 access to some new and untested technology that Firm 2 will use in its products. In return, Firm 2 will share some of the profits from its sales with Firm 1. Who is at risk, Firm 1 or Firm 2? 9.12. For each of the strategic alliances described in the above question, what actions could be taken to reduce the likelihood that partner firms will “cheat” in these alliances? 9.13 Examine the websites of the following strategic alliances and determine which of the sources of value present in Table 9.1 are present in: (a) Dow-Corning (an alliance between Dow Chemical and Corning) (b) CFM (an alliance between General Electric and SNECMA) (c) NCAA (an alliance among colleges and universities in the United States) (d) Visa (an alliance among banks in the United States) (e) The alliance among United, Delta, Singapore Airlines, AeroMexico, Alitalia, and Korean Air Answer 9.11 (a) Firm I has made a transaction-specific investment and Firm II has not. Firm I may be subject to holdup. (b) Firm B could be at risk because once Firm A gets hold of the contacts in Firm B’s country, it no longer “needs” Firm B. (c) Firm 2 may get the technology from 1, learn it, and may “cheat” Firm 1 by no longer accessing technology from Firm 1 and no longer sharing profits with it. Answer 9.12 To reduce the likelihood of partner firms "cheating" in strategic alliances, several actions can be taken: • Establish Clear Objectives and Expectations: Clearly define the goals, roles, responsibilities, and expectations of each partner firm within the alliance. This ensures that all parties understand what is required of them and reduces ambiguity that might lead to opportunistic behavior. • Build Trust and Open Communication Channels: Foster an environment of trust and transparency among partner firms. Encourage regular communication and information sharing to address any issues or concerns promptly. Open channels of communication can facilitate the resolution of conflicts and help prevent misunderstandings that could lead to cheating. • Develop Mutual Benefits and Interdependence: Structure the alliance in a way that creates mutual benefits and interdependence between partner firms. When each firm relies on the other for success, there is a greater incentive to cooperate and uphold the terms of the alliance rather than cheat. • Implement Monitoring and Control Mechanisms: Utilize monitoring and control mechanisms to track the performance and behavior of partner firms. This could include regular audits, performance metrics, and joint review meetings to ensure compliance with the alliance agreement. Monitoring can act as a deterrent to cheating and provide early detection of any deviations from agreed-upon terms. • Establish Legal Safeguards: Draft a comprehensive legal agreement that outlines the terms and conditions of the alliance, including dispute resolution mechanisms and consequences for breaches of contract. Legal safeguards can provide a framework for addressing cheating and offer recourse in case of violations. • Create Incentives for Cooperation: Design incentive structures that reward cooperative behavior and discourage cheating. This could involve profit-sharing arrangements, performance bonuses tied to alliance objectives, or long-term commitments that incentivize partner firms to prioritize the success of the alliance. • Cultivate Relationship Building: Invest in building strong relationships between individuals within partner firms. Personal connections and trust between key stakeholders can serve as a barrier to cheating by fostering a sense of loyalty and commitment to the alliance beyond mere contractual obligations. • Anticipate and Manage Risks: Identify potential risks and challenges that may arise during the course of the alliance and develop strategies to mitigate them. By proactively addressing risk factors, partner firms can reduce the likelihood of situations that might tempt them to cheat. By implementing these actions, partner firms can mitigate the risk of cheating in strategic alliances and build a foundation of trust and collaboration for mutual success. Answer 9.13 To determine which sources of value from Table 9.1 are present in each of the strategic alliances mentioned, let's analyze each alliance: (a) Dow-Corning (an alliance between Dow Chemical and Corning): • Economies of Scale: Both Dow Chemical and Corning may benefit from economies of scale by combining resources, technologies, and expertise in the production and distribution of chemicals and materials. • Economies of Scope: The alliance may enable both firms to leverage their respective capabilities to enter new markets or develop new products, thus achieving economies of scope. • Complementary Resources and Capabilities: Dow Chemical and Corning likely bring complementary resources and capabilities to the alliance, such as Dow's expertise in chemicals and Corning's expertise in glass and ceramics. • Risk Sharing and Reduction: By collaborating, the firms can share risks associated with research and development, market fluctuations, and other uncertainties inherent in their industries. (b) CFM (an alliance between General Electric and SNECMA): • Economies of Scale: CFM may benefit from economies of scale in manufacturing aircraft engines by combining the production capabilities of General Electric and SNECMA. • Complementary Resources and Capabilities: General Electric and SNECMA likely contribute complementary expertise, technologies, and resources to the design, development, and production of aircraft engines. • Risk Sharing and Reduction: The alliance allows both firms to share risks associated with large-scale investments in research, development, and production of aircraft engines, as well as market demand fluctuations. (c) NCAA (an alliance among colleges and universities in the United States): • Pooling of Resources: Member colleges and universities pool their resources, expertise, and networks to organize and govern collegiate athletics competitions and championships. • Risk Sharing and Reduction: The NCAA provides a framework for member institutions to share risks associated with organizing and participating in collegiate sports, such as financial investments, compliance with regulations, and reputational risks. (d) Visa (an alliance among banks in the United States): • Network Effects: Visa benefits from network effects as member banks issue Visa-branded credit and debit cards, expanding Visa's reach and increasing the value proposition for consumers and merchants. • Risk Sharing and Reduction: Member banks share risks associated with payment processing, fraud prevention, and regulatory compliance through their participation in the Visa network. (e) The alliance among United, Delta, Singapore Airlines, AeroMexico, Alitalia, and Korean Air: • Network Effects: The alliance benefits from network effects as member airlines collaborate to offer passengers access to a broader network of routes, destinations, and services, enhancing the value proposition for travelers. • Complementary Resources and Capabilities: Member airlines bring complementary resources and capabilities, such as route networks, aircraft fleets, airport facilities, and passenger services, which can be leveraged to enhance the overall value of the alliance. • Risk Sharing and Reduction: By collaborating, member airlines can share risks associated with fluctuating fuel prices, regulatory changes, geopolitical events, and other factors impacting the airline industry. In summary, each strategic alliance mentioned above exhibits various sources of value as outlined in Table 9.1, including economies of scale, economies of scope, complementary resources and capabilities, network effects, pooling of resources, and risk sharing and reduction. 10 Mergers and Acquisitions CHALLENGE QUESTIONS 10.1. Consider the following scenario: A firm acquires a strategically related target after successfully fending off four other bidding firms. Under what conditions, if any, can the firm that acquired this target expect to earn an economic profit from doing so? The bidding firm can realize an economic profit if the bid price is less than the value of the combined entity. Thus, if the bidding firm has a stand-alone value of $15,000 and the combined value of the bidding and target firm is $25,000, and the bidding firm buys the target for less than $10,000. For example, if the bidding firm buys the target firm for, say, $8,000, it is getting $10,000 value ($25,000 minus $15,000) for $8,000 and thus makes an economic profit of $2,000. 10.2. Consider this scenario: A firm acquires a strategically related target; there were no other bidding firms. Under what conditions, if any, can the firm that acquired this target expect to earn an economic profit from doing so? In the case where there are no other bidders, the possibility of the bidding firm obtaining a profit goes up because there is no competitive market. If the target is unaware of its true value to the bidding firm, the bidding firm may be able to acquire the target for less than its true value. If the target is aware of its value, the bidding firm may be forced to increase the bid higher and higher and as long as it is below $10,000, it will make a profit. Since it is not competing with other firms, the bid price may not go up if the target firm remains unaware of its true value to the bidding firm. 10.3. Some researchers have argued that the existence of free cash flow can lead managers in a firm to make inappropriate acquisition decisions. To avoid these problems, these authors have argued that firms should increase their debt-to-equity ratio and “soak up” free cash flow through interest and principal payments. Is free cash flow a significant problem for many firms? Free cash flow means that the firm has cash idling away. It is doubtful that this is a significant problem for many firms. Free cash flow may lead to temptation in the form of making an unwise acquisition. For example, when Microsoft was sitting on a cash horde of $45 billion, it faced constant pressure to “do something.” Some companies may succumb to these temptations and make ill-advised acquisitions. 10.4 What are the strengths and weaknesses of increased leverage as a response to free cash flow problems in a firm? Taking on debt means the debt has to be serviced – that is interest payments have to be made and principal repaid. This forces the company to use up its free cash flow in strategically sound activities. The weakness of the leverage approach is that the company lets its cash migrate to outsiders. In addition, interest payments have to be paid in good times and in bad. While it imposes discipline, and is, therefore, a strength, it also puts unwanted pressure on the organization. 10.5. The hubris hypothesis suggests that managers continue to engage in acquisitions, even though on average they do not generate economic profits, because of the unrealistic belief on the part of these managers that they can manage a target firm’s assets more efficiently than that firm’s current management. This type of systematic nonrationality usually does not last too long in competitive market conditions. Firms led by managers with these unrealistic beliefs change, are acquired, or go bankrupt in the long run. What are the attributes of the market for corporate control that suggest that managerial hubris could exist in this market, despite its performance-reducing implications for bidding firms? The market for corporate control is not always perfect. Imperfect market conditions occur when there is information asymmetry. Some managers may believe they have access to better or more information that would allow them to be successful at M&A activity. In addition, some managers believe that they can act quickly to capitalize on M&A opportunities. Such attributes of the market for corporate control—information asymmetry and the benefit of speed—may promote managerial hubris. 10.6. The hubris hypothesis suggests that managers continue to engage in acquisitions, even though on average they do not generate economic profits, because of the unrealistic belief on the part of these managers that they can manage a target firm’s assets more efficiently than that firm’s current management. This type of systematic nonrationality usually does not last too long in competitive market conditions. Firms led by managers with these unrealistic beliefs change, are acquired, or go bankrupt in the long run. Can the hubris hypothesis be a legitimate explanation for continuing acquisition activity? Yes, the hubris hypothesis can very well explain the continued interest in acquisition activity in spite of evidence that indicates that, by and large, they don’t create value for the acquirer. It is possible that managers of acquiring companies believe that either they have better managerial skills than others to get value out of an acquisition or that they have information that others do not. 10.7. It has been shown that so-called “poison pills” rarely prevent a takeover from occurring. In fact, sometimes when a firm announces that it is instituting a poison pill, its stock price goes up. Why? Poison pills are actions that target firm managers can take to make the acquisition of a target prohibitively expensive. For example, a poison pill could be the payment of a large cash dividend to stockholders in the event of an unfriendly takeover. Poison pills are put in place to prevent takeovers. But, the announcement of a poison pill being put in place may signal to the market that the firm is undervalued and that it is anticipating a bid. This is likely to increase the price of the target firm’s stock price because investors want to profit from the anticipated takeover. Problem Set 10.8. For each of the following scenarios, estimate how much value an acquisition will create, how much of that value will be appropriated by each of the bidding firms, and how much of that value will be appropriated by each of the target firms. In each of these scenarios, assume that firms do not face significant capital constraints. a. A bidding firm, A, is worth $27,000 as a stand-alone entity. A target firm, B, is worth $12,000 as a stand-alone entity, but $18,000 if it is acquired and integrated with Firm A. Several other firms are interested in acquiring Firm B, and Firm B is also worth $18,000 if it is acquired by these other firms. If A acquired B, would this acquisition create value? If yes, how much? How much of this value would the equity holders of A receive? How much would the equity holders of B receive? b. The same scenario as in a, except that the value of B if it is acquired by the other firms interested in it is only $12,000. c. The same scenario as in a, except that the value of B if it is acquired by the other firms interested in it is $16,000. d. The same scenario as in b, except that Firm B contacts several other firms and explains to them how they can create the same value with Firm B that Firm A does. e. The same scenario as in b, except that Firm B sues Firm A. After suing Firm A, Firm B installs a “supermajority” rule in how its board of directors operates. After putting this new rule in place, Firm B offers to buy back any stock purchased by Firm A for 20% above the current market price. 10.9. How would a firm’s investment in merger and acquisition strategies, on average, be expected to generate at least competitive parity for bidding firms? Answer 10.8 a. If A acquired B, economic value would be created (in the amount of $6,000). The equity holders of A would receive 0 value (assuming that the acquisition price was $18,000 or the value of B when combined with A). The equity holders of the target firm, B, would receive $6,000 in equity. b. In this scenario, Firm A will pay slightly higher than all other bidding firms as the public “value” of the target for all other firms is $12,000 but for Firm A it is $18,000. Therefore, all other firms are only willing to pay up to $12,000 for the target. Firm A, however, is willing to pay (let’s assume) up to $12,001 for the target B. Therefore, the added value for Firm A is $5,999. This added value will accrue to the equity holders of Firm A. The equity holders of Firm B will not receive any additional equity from the acquisition. c. In this scenario Firm A will pay slightly higher than all other bidding firms as the public “value” of the target for all other firms is $16,000 but for Firm A it is $18,000. Therefore all other firms are only willing to pay up to $16,000 for the target. Firm A, however, is willing to pay (let’s assume) up to $16,001 for the target B. Therefore the added value for Firm A is $1,999. This added value will accrue to the equity holders of Firm A. The equity holders of Firm B will gain approximately $6,000 in equity from the acquisition. d. In this scenario, the acquisition price will be $18,000 for Firm B. The firm(s) that acquire the target will earn zero economic profit from the acquisition. However, the owners of the target firm (Firm B) will earn an economic profit worth $6,000. As a stand-alone firm, Firm B is worth $12,000 but worth $18,000 when combined with any of the bidding firms. e. Assuming that Firm B wishes to buy back the stock that Firm A had purchased at a 20% rate above the current market price – Firm A purchased the stock of Firm B for $12,001 (see b above). The “value” of Firm B when combined with Firm A is $18,000. The stand-alone value is $12,000. So Firm A would sell the stock back to Firm B at a rate of 20% over the current value. Therefore, it may cost Firm B $21,600 to purchase the stock back. This would represent a significant “loss” of economic value to equity holders of B; it would, however, represent substantial value to equity holders of A; in the amount of $9,599. Answer 10.9 If a firm invests in merger and acquisition strategies, then it can develop expertise in identifying attractive candidates and being able to price them appropriately. Such activities can help it generate at least competitive parity in the M&A process. 11 International Strategies CHALLENGE QUESTIONS 11.1. Are international strategies always just a special case of diversification strategies that a firm might pursue? What, if anything, is different about international strategies and diversification strategies? International strategies are just a special case of diversification strategies that a firm might pursue. The motivations for both are the same and the yardstick for measuring their success are also identical. 11.2. What, if anything, is different about international strategies and diversification strategies? International strategies, however, are slightly different from diversification strategies in that, in some cases, the motivation may be preemption—like Pepsi getting into Russia ahead of Coca-Cola—or ensuring multi-market competition—like Procter and Gamble going into markets just so that it can weaken Unilever’s stronghold in those markets. 11.3. In your view, is gaining access to low-cost labor a sufficient reason for a firm to pursue an international strategy? Why or why not? In your view, is gaining access to special tax breaks a sufficient reason for a firm to pursue an international strategy? Why or why not? It is important to note that labor costs don’t remain static and they can go up sharply. For example, as more and more firms look to India for call centers, the labor cost of skilled cost center employees has gone up. Gaining access to low-cost labor is often used as the motivation for a firm’s international strategy, but it is fraught with danger as labor costs can and do escalate. Special tax breaks are typically for a limited duration. Using them as a sufficient reason to pursue an international strategy is perhaps shortsighted because the firm has to look beyond the tax break to ensure a competitive advantage in those markets. 11.4. The transnational strategy is often seen as one way in which firms can avoid the limitations inherent in the local responsiveness/international integration trade-off. However, given the obvious advantages of being both locally responsive and internationally integrated, why are apparently only a relatively few firms implementing a transnational strategy? The transnational strategy gives the benefits of both the local responsiveness option and the international integration option. While it is the “best of both worlds,” in practice it is often difficult to pull off. It requires coordination, management of knowledge flow, flexibility in staffing, and constant movement of personnel. 11.5. Can a firm’s transnational strategy be a source of sustained competitive advantage? Not many firms can implement the transnational strategy successfully and hence the transnational strategy has not been adopted by a large number of organizations. This means that, for those companies that strive hard to pull this off, the transnational strategy can help them gain a sustained competitive advantage that will be hard for their competitors to imitate. 11.6. On average, why is the threat of adverse selection and moral hazard in strategic alliances greater for firms pursuing an international strategy or a domestic strategy? Adverse selection has to do with information about the partners prior to the formation of the alliance and moral hazard deals with monitoring issues once the alliance is operational. Accurate information about potential international partners may be hard to get, leading to this being a bigger threat in international alliances as compared to those between domestic ones. The same applies to day-to-day monitoring. Information asymmetry may be accentuated in international alliances due to distance—both physical as well as cultural—and language and regulatory issues. 11.7. How are the organizational options for implementing an international strategy related to the M-form structure described in Chapter 8? Are these international organizational options just special cases of the M-form structure, with slightly different emphases, or are these international organizational options fundamentally different from the M-form structure? In the M-form structure, each division is given the autonomy to pursue its specific product-market objectives with some coordination across divisions to ensure economies of scope. There are a number of similarities between the M-form structure and the international organizational options. For example, in a decentralized federation, each country unit has the autonomy to customize its product-market strategies, just like in a typical M-form structure. What is different, though, is the sharing across organizational units. It is likely to be more in an M-form structure and less in the case of the decentralized federation. However, in other international organizational options, such as the coordinated federation and the transnational structure, there is likely to be the same or more interaction among organizational units as there is in an M-form structure. 11.8. Are international organizational options for implementing an international strategy just special cases of the M-form structure, with slightly different emphases, or are these international organizational options fundamentally different from the M-form structure? Yes, international organizational options are essentially just special cases or variations of the M-form structure. The exception to this may be the transnational organizational structure, which may be, because of its increased need for coordination, an organizational form quite distinct from the M-form. Problem Set 11.9. In which country is it riskiest to begin international operations: Mexico, Argentina, or Poland? Justify your conclusions. 11.10. Your firm has decided to begin selling its mining machinery products in Ghana. Unfortunately, there is not a highly developed trading market for currency in Ghana. However, Ghana does have significant exports of cocoa. Describe a process by which you would be able to sell your machines in Ghana and still translate your earnings into a tradable currency (e.g., dollars or euros). 11.11. Match the actions of these firms with their sources of potential value: (a) Tata Motors (India) acquires Jaguar (U.K.) – new core competencies (b) Microsoft (U.S.) opens four research and development centers in Europe – new core competencies (c) Disney opens Disney-Hong Kong – new customers for current products or services (d) Merck forms a R&D alliance with an Indian pharmaceutical firm – gaining access to low-cost factors of production (e) Lenovo purchases IBM’s laptop computer business – new core competencies (f) Honda Motor Company opens an automobile manufacturing plant in Southern China. Most of the cars it produces are sold in China – new customers for current products or services (g) Honda starts exporting cars made in China to Japan – gaining access to low-cost factors of production (h) A Canadian gold mining company acquires an Australian gold mining company – managing corporate risk Answer 11.9 There are a variety of sources to get political risk ratings for various countries. One such source can be accessed at: http://www.pri-center.com/. The following table presents the political risk profile of the three countries: The factors are rated on a scale of 1-7 with 7 being the riskiest and commercial risk is rated on a scale of A, B, and C, with C being the riskiest. From the table above, Argentina is the riskiest to begin international operations and Poland is the least risky. Interestingly, the commercial prospects appear bleak in all 3 countries. Answer 11.10 This is a good situation to use countertrade. Your firm should use the money generated by selling products in Ghana to buy locally produced cocoa. Since cocoa from Ghana has high export value, your firm should sell Ghana cocoa in the export market for hard currency. This way, the “soft” currency of Ghana can be exchanged for hard currency. Answer 11.11 Adverse selection has to do with information about the partners prior to the formation of the alliance and moral hazard deals with monitoring issues once the alliance is operational. Accurate information about potential international partners may be hard to get, leading to this being a bigger threat in international alliances as compared to those between domestic ones. The same applies to day-to-day monitoring. Solution Manual for Strategic Management and Competitive Advantage Concepts and Cases Jay B. Berney, William S. Hesterly 9781292060088, 9781292258041
