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Strategic Management Final Exam

Chapter 1 What Is Strategy and the Strategic Management Process?


Defining Strategy y Strategy- theory about how to gain competitive advantage o A good strategy is one that generates such advantages y Strategies are based on theories that firm s have to gain competitive advantages these theories are based on a set of assumptions and hypotheses about the way competition in the industry will likely evolve and hoe that evolution can be exploited to earn a profit y It is usually very difficult to predict precisely how competition will evolve and so it is rarely possible to know for sure that a firm is choosing the right strategy o This is why a firm s strategy is almost always a theory

The Strategic Management Process y Strategic management process- a sequential set of analyses and choices that can increase the likelihood that a firm will choose a good strategy

External analysis Mission objectives Internal analysis strategic choice implementation competitive advantage

A Firm s Mission y The first step to the strategic management process y Mission- long-term purpose of the firm o Defines both what a firm aspires to be in the long run and what it wants to avoid in the meantime o Broad statement of purpose and values o Often written in the form of mission statements y Some missions may not affect performance o Most mission statements incorporate many common elements:  Define the business in which the firm will operate  How the firm will compete in those businesses  The core values that a firm espouses y Some missions can improve performance o Visionary firms- firms whose mission is central to all they do  These types of firms usually have long-term profitability y Some missions can hurt firm performance o Sometimes will be focused only on the personal values and priorities of the founders/top managers

Objectives y Objectives- specific and measurable targets a firm can use to evaluate the extent to which it is realizing its mission o high-quality objectives are tightly connected to elements of a firm s mission and are relatively easy to measure and track over time o low-quality objectives either do not exist or are not connected to elements of a firm s mission, are not quantitative, and are difficult to measure or difficult to track over time

External and Internal Analysis y occur simultaneously during the strategic management process y external analysis- identifies the critical threats and opportunities in the firms competitive environment o examines how competition in the environment is likely to evolve and what implications that evolution has for the threats and opportunities a firm is facing y internal analysis- helps a firm indentify its organizational strengths and weaknesses o also helps a firm understand which of its resources and capabilities are likely to be sources of competitive advantage and which are less likely to be sources of such advantages o helps to identify areas within the organization that require improvement and change

Strategic Choice y after a firm has a mission, objectives, and external and internal analyses it is ready to make its strategic choices o strategic choice - theory of how to gain competitive advantage y Strategic choice falls into 2 categories: o Business-level strategies- actions firms take to gain competitive advantages in a single market or industry  Cost-leadership and product differentiation o Corporate level strategies- actions firms take to gain competitive advantages by operating in multiple markets or industries simultaneously  Vertical integration, diversification, strategic alliance, merger & acquisition y The objective when making a strategic choice is to choose a strategy that: o Supports the firm s mission o Is consistent with a firm s objectives o Exploits opportunities in a firm s environment with a firm s strengths o Neutralizes threats in a firm s environment while avoiding a firm s weaknesses

Strategy Implementation y Strategy implementation- occurs when a firm adopts organizational policies and practices that are consistent with its strategy y There are 3 specific organizational policies and practices in implementing strategies: o A firm s formal organizational structure o Its formal and informal management control systems o Employee compensation policies

What is Competitive Advantage? y Competitive advantage- when a firm is able to create more economic value than rival firms emporary competitive advantage- lasts for a very short time o o Sustained competitive advantage- lasts for a much longer time y Competitive parity- companies that create the same economic value as their rivals y Competitive disadvantage- companies that create less economic value than their rivals o emporary- lasts a short time o Sustained- lasts a long time Measuring Competitive Advantage y Not always easy to directly measure y Two approaches for measuring competitive advantage: o Accounting performance- a measure of a firms competitive advantage calculated by using information from its published profit and loss and balance sheet statements  compare with competitors in an industry  this makes it possible to compare one firm to another o Economic measures of competitive advantage- compare a firm s level of return to its cost of capital instead of to the average level of return in the industry  Economic value- the difference between the perceived benefits gained by a customer that purchases a firm s products/services and the full economic cost of these products/services o Thus, the size of a firm s competitive advantage is the difference between the economic value a firm is able to create and the economic value its rivals are able to create  above normal economic profit a firm that is earning above its cost of capital  normal economic profit a firm that is earning its cost of capital  below economic profit a firm that is earning below its cost of capital Emergent versus Intended Strategies y emergent strategies- theories of how to gain competitive advantage in an industry that emerge over time or that have been radically reshaped once they are initially implemented y intended strategy- a strategy a firm though it was going to pursue a rational strategy

Chapter 2 Evaluating a Firm s External Environment


The Structure-Conduct-Performance Model of Firm Performance y Structure-conduct-performance (SCP)- theory which suggests that industry structure determines a firm s conduct which in turn determines its performance Porter s 5 Forces Model y Developed from the SCP Model y Entry high barriers to entry make the industry more attractive because there is a potential for greater than normal returns y Rivalry high rivalry leads to lower profits y Buyers few buyers (buyer power) lead to lower profits y Suppliers few suppliers (supplier power) lead to lower profits y Substitutes can meet the customer s same needs in different ways

Industry Structure and Environmental Opportunities y Fragmented- industries in which a large number of small or medium-sized firms operate and no small set of firms has dominant market share or creates dominant technologies o Many small competitors, no one dominant firm o Opportunity: consolidation strategy that reduces the number of firms in an industry by exploiting economies of scale y Emerging- newly created or newly re-created industries formed by technological innovations, change in demand, of the emergence of new customer needs o No standard put in place, just breaking out o Opportunity: first-mover advantages- advantages that come to firms that make important strategic and technological decisions early in the development of an industry y Mature- an industry in which, over time, ways of doing business have become widely understood, technologies have diffused through competitors, and the rate of innovation in new products and technologies drops o Profits are no longer really growing o Opportunity: product refinement emphasis on service process innovation- a firm s effort to refine and improve its current processes y Declining- an industry that has experiences an absolute decline in unit sales over a sustained period of time o Declining industry leaders are bailing out (exiting) o Opportunity: leadership- the firm with the largest market share in an industry Niche- when a firm reduced its scope of operations and focuses on narrow segments of a declining industry Harvest- when firms engage in a long, systematic, phased withdrawal from a declining industry, extracting as much value as possible Divestment- selling a business with which a firm had been operating

Chapter 3 Evaluating a Firm s Internal Capabilities


The Resources-Based View of the Firm y Resource-Based View (RBV)- a model of firm performance that focuses on the resources and capabilities controlled by a firm as sources of competitive advantage y answers the questions: why do some firms achieve better economic performance than others? o Resources- the tangible and intangible assets that a firm controls, which it can use to conceive of and implement its strategies o Capabilities- a subset of a firm s resources and are defined as tangible and intangible assets that enable a firm to take full advantage of other resources it controls (firm as a whole, not of an individual at the collective firm level)  Ex: marketing skills, teamwork, cooperation

Critical Assumptions of the Resource-Based View y Two critical assumptions: o Resource heterogeneity- different firms may possess different bundles of resources and capabilities, even if they are competing in the same industry  implies that for a given business activity, some firms may be more skilled in accomplishing this activity than others  not all resources/capabilities are alike o resource immobility- some resource and capability differences among firms may be long lasting because it may be very costly for firms without certain resources and capabilities to develop or acquire them o taken together these two assumptions make it possible to explain why some firms can outperform other firms, even if these firms are all competing in the same industry

The Question of Organization y a firm s potential for competitive advantage depends on the value, rarity, and imitability of its resources and capabilities to fully realize its potential, a firm must be organized to exploit its resources and capabilities y whether you are aligning your firm s structure (formal and informal) with resources this is important for sustained competitive advantage y formal reporting structure- a description of who in the organization reports to whom y management control systems- include a range of formal and informal mechanisms to ensure that managers are behaving in ways consistent with a firm s strategies o formal management controls- include a firm s budgeting and reporting activities that keep people higher up in a firm s organizational chart informed about the actions taken by people lower down in a firm s organizational chart o informal management controls- include a firm s culture and the willingness of employees to monitor each other s behavior y compensation policies- the ways that firm s pay employees create incentives for employees to behave in certain ways

Chapter 4 Cost Leadership


What is Cost Leadership? y Cost leadership- focuses on gaining competitive advantages by reducing its costs to below those of all its competitors

Six Important sources of cost advantages for firms: y Size differences and economies of scale- said to exist when the increase in firm size (measures in terms of volume of production) is associated with lower cost (measured in terms of average cost per unit of production) y Size difference and diseconomies of scale- if the volume size of production rises beyond some optimal point, this can actually lead to an increase in per-unit costs o If other firms in an industry have grown beyond the optimal firm size, a smaller firm (with a level of production closer to the optimal) may obtain a cost advantage even when all firms in the industry are producing very similar products o The advantage is for those who do not have diseconomies of scale y Experience differences and learning-curve economies- firms with the greatest experience in manufacturing a product/service will have the lowest cost in an industry and thus will have a cost-based advantage link between cumulative volumes of production and cost o Doing something longer than others learn how to do it better y Differential low-cost access to productive inputs o Productive inputs- any supplies used by a firm in conducting its business activities o A firm that has a differential low cost access to these factors is likely to have a lower economic cost compared to rivals y Technological advantages independent of scale y Policy choices- choices that have an impact on the relative cost position of the firm

Chapter 5 Product Differentiation


What is Product Differentiation? y Product differentiation- a business strategy whereby firms attempt to gain competitive advantage by increasing the perceived value of their products or services relative to the perceived value of other firms products or services Ways Firms can Differentiate their Products: y Directly related to the attributes of the product or service: o Features o Complexity o Timing of product introduction o Location y On relationships between itself and its customers: o Customization o Marketing o Reputation y Linkages within or between firms: o Linkages among functions within a firm o Linkages with other firms o Product mix o Distribution channels o Service and support

Chapter 6 Vertical Integration


What is Corporate Level Strategy? y Corporate strategy is a firm s theory of how to gain competitive advantage by operating in several businesses simultaneously Logic of Corporate Level Strategy y Corporate level strategy should create value: o such that the value of the corporate whole increases o such that businesses forming the corporate whole are worth more than they would be under independent ownership o that equity holders cannot create through portfolio investing y a corporate level strategy should create synergies that are not available in equity markets y vertical integration = value chain economies What is Vertical Integration? y A value chain is a set of activities that must be accomplished to being a product of service from raw materials to the point that it can be sold to the final consumer y Vertical integration the number of steps in the value chain that a firm accomplishes within its boundaries o Backward vertical integration- firm incorporates more stages of the value chain within its boundaries and those stages bring it closer to the beginning of the value chain, that it, closer to gaining access to raw materials  Ex: when computer companies develop their own software they are engaging in vertical integration because these actions are close to the beginning of the value chain o Forward vertical integration- when a firm incorporates more stages of the value chain within its boundaries and those stages bring it closer to the end of the value chain, that is, closer to interacting directly with final customers  Ex: when companies staff and operate their own call centers in the US because these activities bring them closer to the ultimate customer Value Chain Economies y The Logic of Value Chain Economies o the focal firm is able to create synergy with the other firm(s)  cost reduction  revenue enhancement y the focal firm is able to capture above normal economic returns (avoid perfect competition) Value of Vertical Integration y Market vs. Integrated Economic Exchange markets and integrated hierarchies are forms in which: o economic exchange can take place o economic exchange should be conducted in the form that maximizes value for the focal firm o thus, firms assess which form is likely to generate more value y Integration makes sense when the focal firm can capture more value than a market exchange provides

Value of Vertical Integration y Three value considerations: o Leverage capabilities- enabling the firm to exploit the VRIO resources and capabilities  This approach has 2 broad implications: y Suggests that firms should vertically integrate into those business activities where they possess valuable, rare, and costly-to-imitate resources and capabilities this way, the firm can appropriate at least some of the profits that using these capabilities to exploit environmental opportunities will create y Suggests that firms should not vertically integrate into business activities where they do not possess the resources necessary to gain competitive advantages o Thus, if a firm possesses valuable, rare, and costly-to-imitate resources in a business activity, it should vertically integrate into that activity  firm capabilities may be sources of competitive advantage in other businesses  if not, then don t integrate exchange o manage opportunism- reducing the threat of opportunism  vertical integration can reduce the threat of opportunism- exists when a firm is unfairly exploited in an exchange y ex: when a party to an exchange expects high level of quality in a product it is purchasing, only to discover it has received a lower level of quality than it expected  opportunism may be checked by internalizing (TSI) bring the exchange within the boundary of the firm y managers can directly monitor and control this exchange that is brought within the boundary of a firm brings a firm closer to its ultimate suppliers (backward), if the exchange that is brought within the boundary of a firm brings a firm closer to its ultimate customer (forward)  internalizing must be less costly than opportunism  transaction-specific investment- any investment in an exchange that has significantly more value in the current exchange than it does in alternative exchanges y ex: the oil and the pipeline company the pipeline company has more to lose o exploit flexibility- enabling the firm to retain flexibility  flexibility- refers to how costly it is for a firm to alter its strategic and organizational decisions y flexibility is high when the cost of changing strategic choices is low y flexibility is low when the cost of changing strategic choices is high y vertically integrating is less flexible than not vertically integrating because once a firm has integrated it has committed its organizational structure, management controls, and its compensation policies to a particular vertically integrated way of doing business  internalizing is usually less flexible  flexibility is prized when uncertainty is high y flexibility is not always valuable y it is only valuable when the decision-making setting a firm is facing is uncertain y a decision making setting is uncertain when the future value of an exchange cannot be known when investments in that exchange are being made o in these situations less vertical integration is better than more vertical integration 8

Rarity of Vertical Integration y Integration vs. Non-Integration o a firm s integration strategy may be rare because the firm integrates or because the firm does not integrate o thus, the question of rareness does not depend on the number of forms observed o a firm s integration strategy is rare or common with respect to the value created by the strategy  Example: Toyota s Choice Not to Integrate Suppliers Imitability of Vertical Integration y Form vs. Function o the form, per se, is usually not costly to imitate o the value-producing function of integration may be costly to imitate, if:  the integrated firm possesses resource combinations that are the result of: y historical uniqueness y causal ambiguity y social complexity o small numbers prevent further integration o capital requirements are prohibitive Imitability of Vertical Integration y Modes of Entry o acquisition and internal development are alternative modes of entry into vertical integration  thus, one firm may acquire a supplier while a competitor could imitate that strategy through internal development  in both cases, the boundaries of the firm would encompass the new business o strategic alliances can be viewed as a substitute for vertical integration without the costs of ownership Organizing Vertical Integrations y the organizational structure that is used to implement cost leadership and product differentiation (the functional or U-form structure) is also used to implement a vertical integration strategy o decisions about which activities to vertically integrate into determine the range and responsibilities of the marketing function within a functionally organized firm o vertical integration decisions made by the firm determine the structure of a functionally organized firm Management Controls y What needs to be controlled in a vertically integrated firm? y managers efforts to achieve the desired value chain economies o cooperation and competition among and between functions o the integration of new businesses into the existing business o time horizon of managers

Organizing Vertical Integrations y Management Controls o Budgets  separating strategic and operational budgets  strategic: inputs and outputs  operational: outputs o Board Committees  provide oversight and direction to managers y operations committees- typically meets monthly and usually consists of the CEO and each of the heads of the functional areas included in the firm y executive committees- typically consists of a CEO and 2 or 3 functional senior managers  help ensure that strategic direction is maintained y These mechanisms focus management attention on achieving value chain economies Organizing Vertical Integrations y Compensation challenges: o Opportunism bases vertical integration and compensation policy:  This suggests that employees who make firm-specific investments in their jobs will often be able to create more value for a firm than employees who do not make firm-specific investments y These are a type of transaction specific investment y Firm specific investments- investments made by employees that have more value in a particular firm than in alternative firms  Needs to create incentives for employees whose firm-specific investments could create great value to actually make those investments  Opportunism: y Salary y Cash bonus: Individual y Stock grants: Individual o Capabilities and Compensation  Also acknowledge the importance of firm-specific investments in creating value for a firm  Capabilities explanations tend to focus on firm-specific investments made by groups of employees y Socially complex in nature teamwork, cooperation, culture have evolved within a firm can all increase the value of a firm significantly and are all costlyto imitate  Leveraging Capabilities: y Cash bonus: Group y Stock Grants: Group o Flexibility and Compensation  Compensation must have known downside risks and significant upside potential  Exploiting Flexibility: y Stock options: individual y Stock options: group

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Vertical Integration Options When Perusing International Market Opportunities y Not vertically integrated- importing/exporting y Somewhat vertically integrated- licensing, strategic alliances, joint ventures y Vertically integrated- foreign direct investment Summary: y Vertical integration: o makes sense when value chain economies can be created and captured o may allow a firm to leverage capabilities o may be a response to the threat of opportunism and uncertainty o as a form of exchange per se, is not rare nor costly to imitate o is an important consideration in the decision to expand internationally (range of possibilities) o makes sense when done for the right reasons, under the right circumstances o can be a costly mistake if done wrong o Ownership is costly integrates only when the benefits outweigh the costs of integration!

Chapter 7 Corporate Diversification


What is Corporate Diversification? y Corporate diversification- a firm implements this strategy when it operates in multiple industries or markets simultaneously o Product diversification strategy- when a firm operates in multiple industries simultaneously o Geographic market diversification- when a firm operates in multiple geographic markets simultaneously y Product-market diversification- when a firm implements both of these types of diversification simultaneously Logic of Corporate Level Strategy y Corporate level strategy should create value: o such that businesses forming the corporate whole are worth more than they would be under independent ownership o that equity holders cannot create through portfolio investing y Therefore: o a corporate level strategy must create synergies o economies of scope diversification Integration and Diversification y Integration Raw materials Supplier focal firm distribution customer Backward Forward y Diversification Other businesses current businesses other businesses No links unrelated related many links

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Types of Corporate Diversification y At a general level: o Product diversification operating in multiple industries o Geographic market diversification operating in multiple geographic markets o Product-market diversification operating in multiple industries in multiple geographic markets Types of Corporate Diversification y At a more specific level: o Limited diversification when all or most of its business activities fall within a single industry and geographic market  single business: > 95% of sales in single business  dominant business: 70% to 95% in single business o related diversification when less than 70% of a firm s revenue comes from a single product market and its multiple lines of business are linked  related-constrained: all businesses related on most dimensions 70% of firm revenues comes from a single business, and different businesses share numerous links and common attributes  related-linked: some businesses related on some dimensions less than 70% of a firms revenues comes from a single business, and different businesses share only a few links and common attributes or different links and common attributes o unrelated diversification  businesses are not related: less than 70% of firm revenue comes from a single business, and there are few, if any, links or common attributes among business Product and Geographic Diversification y Possibilities: o single-business in one geographic area o single-business in multiple geographic areas o related-constrained in one or multiple geographic areas related-linked in one or multiple geographic areas o unrelated in one or multiple geographic areas y Note: o relatedness usually refers to products o seemingly unrelated products may be related on other dimensions Competitive Advantage y If a diversification strategy meets the VRIO criteria it may create competitive advantage Value of Diversification y Economies of scope- exist in a firm when the value of the products or services it sells increases as a function of the number of businesses that firm operates in o the term scope refers to the range of businesses in which diversified firms operate in o for this reason, only diversified firms can exploit economies of scope o economies of scope create value to the extent that they increase a firm s revenues or decrease its costs compared to what would be the case if these economies were not exploited

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Two criteria for Value of Diversification: y There must be some economy of scope y The focal firm must have a cost advantage over outside equity holders in exploiting any economies of scope Economies of Scope y Operational o Sharing activities exploiting efficiencies of sharing business activities  Ex: Frito-Lay s Tucking o Spreading Core Competencies exploiting competencies in other businesses  Competency must be strategically relevant  Ex: orbits y Financial o Internal capital market  premise: insiders can allocate capital across divisions more efficiently than the external capital market  works only if managers have better information  may protect proprietary information  may suffer from escalating commitment  Ex: Hanson Trust, PLC o Risk Reduction  counter cyclical businesses may provide decreased overall risk  However individual investors can usually do this more efficiently than a firm  Ex: snow skis and water skis o Tax advantages  transfer pricing policy allows profits in one division to be offset by losses in another division  this is especially true internationally  can be used to smooth income  Ex: Ireland y Anticompetitive o Multipoint competition  Mutual forbearance  a firm chooses not to compete aggressively in one market to avoid competition in another market  ex: American airlines and delta: Dallas and Atlanta o Market Power  Using profits from one business to compete in another business  Using buying power in one business to obtain advantage in another business y Managerialism o Maximizing management compensation  an economy of scope that accrues to managers at the expense of equity holders  managers of larger firms receive more compensation (larger scope = more compensation)  therefore, managers have an incentive to acquire other firms and become ever larger  even though the incentive is there, it is difficult to know if managerialism is the reason for an acquisition 13

Equity Holders and Economies of Scope y Most economies of scope cannot be captured by equity holders o risk reduction can be captured by equity holders y Managers should consider whether corporate diversification will generate economies of scope that equity holders can capture o if a corporate diversification move is unlikely to generate valuable economies of scope, managers should avoid it

Rareness of Diversification y Diversification per se is not rare y Underlying economies of scope may be rare o relationships that allow an economy of scope to be exploited may be rare o an economy of scope may be rare because it is naturally or economically limited  a soft drink bottler buys the only source of spring water available  a hotel in a resort town creates a large water park, there are only enough customers to support one park

Imitability of Diversification y Duplication of economies of scope o Less costly-to-duplicate  Employee compensation  Tax advantages  Risk reduction  Shared activities may be costly depending on relationships o Costly-to-duplicate  Core competencies  Internal capital allocation  Multipoint competition  Exploiting market power

Substitution for Diversification y Internal development o Start a new business under the corporate whole o A firm may grow and develop each of its businesses separately o Avoids potential cross-firm integration issues y Strategic alliances o Find a partner with the desired complementary assets o Less costly than acquiring a firm

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International Diversification y Three types of international risk: o Cultural/popular  product may not be accepted simply because of your country or origin y Ex: resistance to McDonald s by France s older generation o Financial  Currency exchange  General economic conditions y Ex: Asian economic crisis of the 1990s o Political  Nationalization  Quotas  Tariffs  Regulations y Ex: Bolivia nationalized its petroleum industry in the 70 s International Diversification y Managing international risks o Cultural/popular  Avoidance  Neutral branding (disguising country of origin) y Ex: Haagen-Dazs o Financial  Currency hedging  Geographic diversification y Spreading risk across several countries o Political  Find a local partner  Political neutrality  Negotiation with governments y Foreign governments often have an interest in direct investment y Ex: case international in brazil Quantifying Political Risks y Country attributes summarize most of the important determinants of political irk for firms pursuing international strategies y Firms can apply the criteria by evaluating the political and economic conditions in a country and by adding up the scores associated with the conditions y Countries in western Europe and North America are least risky o The least risky country in the entire world to do business with is Luxembourg followed by Switzerland, Norway, Denmark, US, and Sweden y Countries currently experiencing civil unrest and revolution are among the most risky o The most risk country in the entire world to do business with is North Korea followed by Afghanistan, Iraq, Cuba, Marshall Islands, and Zaire y Countries in Asia range from very low risk to very high risk y Countries in Africa tend to be relatively risky

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Summary y Corporate Strategy: In what businesses should the firm operate? o an understanding of diversification helps managers answer that question y Two criteria: o Economies of scope must exist o Must create value that outside equity holders cannot create on their own y Economies of scope o A case of synergy combined activities generate greater value than independent activities o may generate competitive advantage if they meet the VRIO criteria y Firms should pursue diversification only if careful analysis shows that competitive advantage is likely! Strategy in Depth y Diversifying to reduce a risk generally doesn t directly benefit outside equity investors it can indirectly benefit outside equity investors through its impact on the willingness of other stakeholders in a firm to make firm-specific investments o Stakeholders- groups and individuals who have an interest in how a firm performs o Firm-specific investments- the value of the investments made in a particular firm are much greater than the value of those same investments would be in other firms o Firm-specific human capital- include understanding a particular firm s culture, policies, and procedures y Supplies and customers can make these types of investments o Suppliers when they customize their products to the specific requirements of a particular customer o Customers customize their operations to fully utilize the products of a particular firm y Firm-specific investments are risky, but they are extremely important to a firm if it is going to be able to generate economic profit y Firm-specific investments are more likely to be valuable, rare, and costly-to imitate compared to nonfirm specific investments y Because of the riskiness involves, generally only be willing to make these investments if some of the riskiness associated with making them can be reduced o It is usually very costly to diversify the risks that are associated with making these investments on their own stakeholders prefer that the firm s managers help manage the risk for them o Can do this by diversifying the portfolio of the businesses in which the firm operates o Equity holders have an indirect incentive to encourage a firm to pursue a diversification strategy y Simply put a firm s diversification strategy can be thought of as compensation for the firm-specific investments that a firm s employees, suppliers, and customers make in a firm o Outside equity holders have an incentive to encourage this compensation in return for access to some of the economic profits that these firm0specific investments can generate

Chapter 8 Organizing to Implement Corporate Diversification


Implementation Issues y How information flows y Where and by whom are decision made y How to influence the behavior of people y How can the interests of employees be aligned with the interests of the firm?

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Organizational Structure and Implementing Corporate Diversification y Multidivisional (M-Form)- the most common organizational structure for implementing a corporate diversification strategy o Each business that the firm engages in is managed through a division o Divisions- strategic business units (SBU) o The M-form is designed to create checks and balances for managers that increase the probability that a diversified firm will be managed in ways consistent with the interests of the equity holders board of directors Senior executive Finance legal accounting | R &D sales human resources Division general manager A Division general manager B Division general manager C Division A Division B Division C Roles and Responsibilities of Major Components of the M-Form Structure y Board of directors- monitor decision making in a firm to ensure that it is consistent with the interests of outside equity holders y Institutional investors- monitor decision-making to ensure that it is consistent with the interests of major institutional equity investors y Senior executives- formulate corporate strategies consistent with equity holders interests to assure strategy implementation o Decide the businesses in which the firm will operate o Decide how the firm should compete in those businesses o Specify the economies of scope around which the diversified firm will operate o Encourage cooperation across divisions to exploit economies of scope o Evaluate performance of divisions o Allocate capital across divisions y Corporate staff- provides information to the senior executive about internal and external environments for strategy formulation and implementation y Division general managers- formulate divisional strategies consistent with corporate strategies and assure strategy implementation o Decide how the division will compete in its business o Coordinate the decision and actions of functional managers reporting to the division general manager to implement divisional strategy o Compete for corporate capital allocations o Cooperate with other divisions to exploit corporate economies of scope y Shared activity managers- support the operations of multiple divisions The Need for Organizational Structure y Information processing requirements o as organizations become larger and more complex, information processing requirements exceed individual capacity  bounded rationality  satisficing instead of choosing the actual best mathematical outcome, chose what is good enough this occurs because if information overload o organizational structure divides information processing into manageable blocks (span of control) 17

The Agency Relationship y A trade off o M-Form Structure o Divides information processing requirements into manageable blocks divides owners from managers o Interests of owners and manages may diverge The Agency Relationship y Managing agency o Principals:  Individual shareholders  Institutional shareholders  Can have a dual role o Monitors:  Board of directors o Agents:  Senior executive  Corporate staff  Division general managers  Shared activity managers The Office of the President o Chairman of the board (monitoring) o Chief Executive Office (strategy formulation) o Chief Operating Officer (strategy implementation) y One person: o Chairman CEO COO y Two people: o Chairman o CEO COO  Or o Chairman CEO o COO y Three people: o Chairman o CEO o COO The Office of the President y Information Filtering o information about the divisions businesses is filtered as it rises to the senior executive  the senior executive can manage the information flow o information flow should not exceed the bounded rationality of managers at any level in the organization o information should flow should be matched with decision-making authority

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Management Controls y Evaluating divisional performance- because divisions are profit-and-loss centers, evaluating divisional performance should be straightforward divisions that are very profitable should be evaluated more positively than divisions that are less profitable o Measurement  Accounting : y Diversified firms use three standards of comparison when evaluating the performance of a division: y A hurdle rate that is common across all the different business units in a firm y A division s budgeted level of performance y The average level of profitability of firms in a division s industry  Economic: y Economic value added (EVA) calculated by subtracting the cost of capital employed in a division from that division s earnings y EVA = adjusted acct earnings (WACC X total capital employed by a division) o Economies of Scope and the Ambiguity of Divisional Performance  It is not possible to unambiguously evaluate the performance of individual divisions in a firm  The fact that there are economies of scope in a diversified firm means that all of the businesses in a firm operates in are more valuable bundled together than they would be if kept separate from one another y Solutions: o Force businesses in a diversified firm to operate independently of each other unable to recognize the economies of scope that were the justification of diversification in the first place o The quantitative evaluation of divisional performance (accounting or economic) must be supplemented by the experience and judgment of senior executives in a diversified firm o Allocating costs and revenues y Allocating capital a potentially valuable economy of scope, for internal capital allocation to be a justification for diversification, the information made available to senior executives allocating capital must be superior in amount and quality to the information available to external sources of capital in the external capital market o Both the quality and the quantity for the information available in an internal capital market depend on the organization of the diversified firm o Managers want to look good general managers have a strong incentive to overstate their division s prospects and understate it s problems o Zero-based budgeting- corporate execs create a list of all capital allocation requests from divisions in a firm and rank them in order of importance and fund all the projects a firm can afford

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Transferring intermediate products o The existence of economies of scope across multiple divisions in a diversified firm often means that products or services produced in one division are used as inputs as products/services in a second division  Intermediate products/services- can be transferred between and of the units in an Mform organization  This transfer is most important and problematic when it occurs between profit center divisions o The transfer of intermediate products/services is managed through a transfer-pricing system one division sells its product/service to a second division for a transfer price this price is set by the firm s corporate management to accomplish corporate objectives o Setting prices y Exchange autonomy o buying and selling division general managers are free to negotiate transfer price without corporate involvement o transfer price is set equal to the selling division s price to external customers y Mandated Full Cost o Transfer price is set equal to the selling division s actual cost of production o Transfer price is set equal to the selling division s standard cost (the cost of production if the selling division were operating at max efficiency) y Mandated Market-based o Transfer price is set equal to the market price in the selling division s market y Dual pricing o Transfer price for the buying division is set equal to the selling division s actual or standard costs o 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

Compensation Policies y Compensation committee o In theory:  represents interests of owners in setting compensation of top executive team  sets compensation based on performance or market o in practice:  sometimes appear to be beholden to executives  compensation decisions often bear little relationship to performance y Aligning incentives o Research shows:  For the CEO and senior managers stock options and stock grants are tied to performance  Cash bonus and salary are not tied to performance o Theory predicts:  stock options and stock grants have a long time horizon  cash bonus and salary have a short time horizon 20

Refocusing y Corporate level strategy may call for exiting a business o a conglomeration discount may exist  the corporation may lack necessary skills  expected economies of scope may not exist o the corporation may need funds for core activities International Implementation y Global strategy o Centralized hub strategic and operational decisions are retained at corporate headquarters  Facilitates global integration same product everywhere you go  Exploits a global product  Exploits scale economies y Multi-domestic strategy o Decentralized federation- strategic and operational decisions are delegated to divisions or country companies  Highly autonomous units  Very responsive locally o Coordination federation- operational decisions are delegated to divisions or country companies; strategic decisions are retained at corporate headquarters  Less autonomous  Some shared activities between divisions y Transnational structure- strategic and operational decisions are delegated to those operational entities that maximize responsiveness to local conditions and international integration o Facilitates both local responsiveness and global integration o Country managers are responsible for exploiting economies of scope o Corporate HQ constantly scans the globe looking for best practices Summary y Successful implementation is a matter of: o appropriately breaking information processing into manageable blocks o aligning the interests of owners and managers y these can be accomplished through: o organizational structure o management controls o compensation policies Strategy in Depth y agency relationship- whenever one party to an exchange has delegated decision making authority to a second party o principal- the party delegating the decision making authority (a firm s outside equity holders) o agent- the party to whom the authority is delegated to (firm s managers) y agency problems- when parties in an agency relationship differ in their decision-making objectives o managerial perquisites investments that to not ass economic value to the firm but do directly benefit managers o managerial risk aversion managers are not indifferent to the riskiness of investment opportunities 21

Strategy in the Emerging Enterprise y corporate spin-off- exists when a large, typically diversified firm divests itself of a business in which it has historically been operating and the divested business operates as an independent entity o a way that new firms can enter into the economy y initial public offering (IPO)- when the stock of a privately held firm, or a division of a corporation, is first sold to the general public y three reasons why larger diversified firms might spin off businesses they own: o the efficient management of these businesses may require very specific skills that are not available in a diversified firm o anticipated economies of scope between a business and the rest of the diversified firm may turn out to not be available o in order to fund other of the firm s businesses y firms are most likely to spin off businesses that are: o unrelated to a firm s corporate diversification strategy o Performing poorly compared to other businesses in the firm o Relatively small y The greater the level of merger and acquisition activity, the more likely that a business owned by a corporation in such an industry will be spun off an indicator of the number of people interested in purchasing the spun off business

Chapter 9 Strategic Alliances


What is a Strategic Alliance? y Strategic Alliance- Any cooperative effort between two or more independent organizations to develop, manufacture, or sell products or services o Three types of Alliances  Non-equity alliance- cooperation between firms is managed directly through contracts, without cross-equity holdings or an independent firm being created y Contracts o Licensing- one firm allows others to use its brand name to sell products o Supply- one firm agrees to supply to others o distribution agreements- one firm agrees to distribute the products of others  Equity alliance- cooperative contracts are supplemented by equity investments by one partner in the other partner sometimes these investments are reciprocated y Cross equity holdings y Partners own stakes in each other  Joint venture- cooperating firms form an independent firm in which they invest. Profits from this independent firm compensate partners for this investment y Joint equity holdings y Independent firm is created and owned by the partners

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Motivation for Alliances y Create economic value by: o accessing complementary resources and capabilities o leveraging existing resources and capabilities y An alliance is an organizational form of exchange that: o should produce a gain from trade due to some comparative or absolute advantage y Implication: Choose partners that are better at something than you are (complementary resources) How Strategic Alliances Create Value y Improve current operations: o Exploiting economies of scale  partner brings increased market share and/or manufacturing capacity o learning from partners  a partner brings technology and/or market knowledge o risk and cost sharing  a partner bears a portion of the risk and/or cost of the alliance y Shaping the competitive environment o Facilitating technology standards  partners may agree on a standard and avoid a market battle for the standard  network industries- industries where single technical standards and increasing returns to scale tend to dominate, competition in these industries tends to focus on which of several competing standards will be chosen y increasing returns to scale- in network industries, the value of a product/service increases as the number of people using it increases o facilitating tacit collusion  partners may communicate within an alliance in subtle, legal ways whereas the same communication between competitors outside an alliance would be illegal y Facilitating entry and exit o Low-cost entry into new industries  a partner provides instant access and legitimacy o Low-cost exit from industries  a partner is an informed buyer o Managing uncertainty  alliances may serve as real options- option that a firm buys under uncertain conditions to retain the ability to move quickly into a market if valuable opps present themselves o Low-cost entry into new geographic markets  partners provide local market knowledge, access, and legitimacy with governments and customers Challenges to Value Creation and Allocation y Incentives to Misappropriate Value (Cheat) o An alliance is an exchange context in which:  partner inputs may be difficult to monitor  actual value creation may be difficult to monitor o value appropriation (allocating the value) may be:  difficult to monitor  subject to power dynamics 23

Three Forms of Misappropriating Value y Holdup exploiting the transaction-specific investment of partners o When one firm makes more transaction-specific investments in a strategic alliance than partner firms make o Transaction specific investment whenever an investment s value in its first-best use (within the alliance) is much greater than its value in its second-best use (outside of the alliance) y Moral hazard providing inputs of lesser value than promised o Partners in an alliance may possess high-quality resources and capabilities of significant value in an alliance, but fail to make those resources and capabilities available to alliance partners y Adverse selection misrepresenting the value of inputs o ad vertise something that you do not actually have o Exists when an alliance partner promises to bring to an alliance certain resources that it either does not control or cannot acquire

Sustained Competitive Advantage y Are strategic alliances rare? o As a form of organizing economic exchange, NO! y However, the sources of value creation within alliances may be rare y The strategic alliances aren t rare, but the value they create may be considered rare o firms may form a combination of complementary resources within an alliance that is rare o the stock of such complementary resources may be limited so that first movers have a rare combination y Are strategic alliances costly to imitate? o As a form of organizing economic exchange, NO!  the organizational form per se is easily duplicated y However, the resource combinations that create value in alliances may be very costly, if not impossible, to imitate if: o the value creating combination depends on social complexity (trust), causal ambiguity, and/or historical uniqueness

Substitutes for Strategic Alliances y Going it alone- when firms attempt to develop all of the resource and capabilities they need to exploit market opportunities and neutralize market threats by themselves o sometimes can create the same, or more, value than using alliances y alliances will be preferred over going it alone when: o the level of transaction-specific investment required to complete an exchange is moderate o an exchange partner possesses valuable, rare, and costly-to-imitate resources and capabilities o there Is great uncertainty about the future value of an exchange y alliances will be preferred over acquisitions when: o there are legal constraints on acquisitions o acquisitions limit a firm s flexibility under conditions of high uncertainty o there is substantial unwanted organizational baggage in an acquired firm o the value of a firm s resources and capabilities depends on its independence

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Organizing Strategic Alliances y Governance responses to the challenges of value creation and allocation y Formal/codified o Explicit Contracts & Legal Sanctions  creates mutual understanding  imposes costs for cheating  conflict resolution o equity investments  aligns interests of partners through ownership in each other  indirect effect o joint ventures  aligns interests of partners through ownership of independent firm  direct effect y informal o firm reputations  the shadow of the future constrains cheating o trust  may allow partners to exploit opportunities that would be infeasible with other mechanisms y These responses are not mutually exclusive: o contracts may be used with equity investments and joint ventures along with firm o reputation and trust reputation and trust come into play in every type of alliance o Reputation and trust may be sources of competitive advantage because they are costly to imitate International Expansion y Alliances may be attractive because: o Local market knowledge is usually critical o governments may require a local partner o international expansion may be:  fraught with uncertainty  high risk  expensive o alliance investment may be more easily reversed than internal development or acquisition Summary: y Successful alliance managers will: o create alliances that will produce gains from trade complementary resources o identify the sources of value creation o assess the likelihood of challenges to value creation and allocation o adopt appropriate governance responses to the challenges to value creation and allocation y Alliances may generate competitive advantage if: o combinations of complementary resources meet the VRIO criteria o governance responses meet the VRIO criteria y The Big Challenge of Strategic Alliances: o Maximizing gains from trade while minimizing the threat of cheating

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Strategy in Depth y Learning race- exists in a strategic alliance when both parties to that alliance seek to learn from each other, but when the rate at which these two firms learn varies o the first firm to learn what it wants to learn from an alliance has the option to begin to under invest in (or even withdraw) from the alliance o able to prevent the slow learning firm from learning all it wanted to from the alliance o if competitors winning a learning race can create a sustained competitive advantage y firms may vary in learning rates because: o may be looking at different things o may differ in terms of their ability to learn absorptive capacity o firms can engage in activities to try to slow the rate of learning of their alliance partners y learning races are common with entrepreneurial and large firms o entrepreneurial often looking to learn about managerial functions required to bring a product to market (difficult) o large firms looking to learn about technology (less difficult) y large firms typically win the learning race

Chapter 10 Mergers and Acquisitions


Logic of corporate level strategy applies y Corporate level strategy should create value: o such that the value of the corporate whole increases o such that businesses forming the corporate whole are worth more than they would be under independent ownership o that equity holders cannot create through portfolio investing Mergers and Acquisitions Defined o Mergers two firms are combined on a relatively co-equal basis  parent stocks are usually retired and new stock issued  name may be one of the parents or a combination  one of the parents usually emerges as the dominant management o Acquisitions one firm buys another firm  can be a controlling share, a majority, or all of the target firm s stock  can be friendly or hostile  usually done through a tender offer y the words are often used interchangeably even though they mean something very different y merger sounds more amicable, less threatening Do Mergers and Acquisitions Create Value? y The logic: o Unrelated M&A Activity  there would be no expectation of value creation due to the lack of synergies between businesses  there might be value creation due to efficiencies from an internal capital market  there might be value creation due to the exploitation of a conglomerate discount o a corporate raider who buys and restructures firms

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Types of Mergers and Acquisitions y Federal Trade Commission (FTC )Categories: o Related:  Vertical- a firm acquires former suppliers or customers  Horizontal- a firm acquires a former competitor  Product extension- a firm gains access to complementary products through an acquisition  Market extension- a firm gains access to complementary markets through an acquisition o Unrelated:  Conglomerate- there is no strategic relatedness between a bidding and a target firm Economic Profits in Unrelated Acquisitions y The target firm object of the acquisition has a current market value of $10,000 y The bidding firms have a current market value of $15,000 y Because there is no strategic relatedness between the bidding firms and the target firm, the value of the bidding firms when combined with the target firm equals the sum of the value of these firms as separate entities the value of the combined would be $25,000 o Bidding firms will be willing to pay a price for a target up to the value that the target firm adds to the bidder once it is acquired any price less than $10,000 will be a source of economic profit for the bidding firm o The bidding will increase until it reaches $10,000 thus the bidding firm will earn a zero economic profit Different Sources of Relatedness between Bidding and Target Firms y Lubatkin s List of Potential Sources of bidder-target relatedness: o Technological economies  Scale economies that occur when the physical processes inside a firm are altered so that the same amounts of input produce a higher quantity of outputs  Sources of technical economies include marketing, production, experience, scheduling, banking, and compensation o Pecuniary economies  Economies achieved by the ability of firms to dictate prices by exerting market power o Diversification economies  Economies achieved by improving a firm s performance relative to its risk attributes or lowering its risk attributes relative to its performance  Sources of diversification economies include portfolio management and risk reduction Economic Profits in Related Acquisitions y If bidding and target firms are strategically related, then the economic value of these 2 combined firms is greater than their economic value as separate entities y 1 target and 10 bidding firms, market value of the target is 10,000 and the bidding firms is 15,000 o When any of the bidding firms and the target firm are combined the value is 32,000 y Bidding firms will be willing to pay a price for a target up to the value that a target firm adds once its acquired max bidding price is 17,000 y The successful bidding firm will bid 17,000 and earn zero economic profit y The target firm will earn an economic profit of 7,000 27

Do Mergers and Acquisitions Create Value? y The logic: o Related M&A activity o Value creation would be expected due to synergies between divisions  Economies of scale  Economies of scope y Transferring competencies y Sharing infrastructure y The empirical evidence: o Research is based on stock market reaction to the announcement of M&A activity o this reflects the market s assessment of the expected value of the merger or acquisition o these studies look at what happens to the price of both the acquirer s stock and the target s stock  thus, we can see who is capturing any expected value that may be created y M&A activity creates value, on average, as follows: o Acquiring firms no value created o Target firms value increases by about 25% o Related M&A activity creates more value than unrelated M&A activity o M&A activity creates value, but target firms capture it y Expected vs. operational value

Possible Motivations to Engage in Acquisitions Even Though they usually don t Generate Profits for Bidding Firms y Survival: o Avoid competitive disadvantage o Avoid sale disadvantages y Free cash flow: o the amount of cash a firm has to invest after all positive net present value investments in its ongoing businesses have been funded o Cash generating, normal return investment y Agency problems o Managers benefit from increases in size o Managers benefit from diversification y Managerial hubris: o Unrealistic belief held by managers in bidding firms that they can manage the assets of a target firm more efficiently than the target firm s current management o Managers believe they can beat the odds y Potential for Above normal profits:  some M&A activity does generate above normal profits (expected and operational over the long run)  proposed M&A activity may satisfy the logic of corporate level strategy  managers may see economies that the market can t see

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Jensen and Ruback s List of Reasons Why Bidding Firms Might Want to Engage in Acquisition Strategies y to reduce production and distribution costs: o through economies of scale o through vertical integration o through the adoption of more efficient production or organizational technology o through the increased utilization of the bidder s management team o through a reduction of agency costs by bringing organization-specific assets under common ownership y Financial Motivations: o To gain access to underutilized tax shields o To avoid bankruptcy costs o To increase leverage opportunities o To gain other tax advantages o To gain market power in product markets o To eliminate inefficient target management Competitive Advantage y Can an M&A strategy generate sustained competitive advantage? o Yes, if manager s abilities meet VRIO criteria:  Managers may be good at recognizing & exploiting potentially value-creating economies with other firms  Managers may be good at doing deals  Managers may be good at both y Recognizing and exploiting economies of scope o Private economies: example  Firm C s recognized value is $10,000  Firm A sees value of $12,000 in Firm C  Firm A can earn a profit of $2,000 only if the economy remains private o Costly to imitate economies: example  if the economy between A & C is costly to imitate, it doesn t matter if other firms know  Firm A can still earn a $2,000 profit o Unexpected economies: example  Firm C has a market value of $10,000  Firm A buys Firm C for $10,000  Firm C turns out to be worth $12,000 Rules for Bidding Firm Managers y Search for valuable and rare economies of scope y Limit information to other bidders y Limit information to the target y Avoid winning bidding wars y Close the deal quickly y Operate in thinly traded acquisition markets o A market where there are only a small number of buyers and sellers, where information about opportunities in the market is not widely known, and where interests besides purely maximizing the value of a firm can be important

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Rules for Target Firm Managers y Seek information from bidders y Invite other bidders to join in bidding contest y Delay, but do not stop the acquisition

Implementation Issues y Structure, control, and compensation o M&A activity requires responses to these issues:  m-form structure is typically used  management controls & compensation policies are similar to those used in diversification strategies o Managers must decide on the level of integration:  target firm may remain somewhat autonomous  target firm may be completely integrated y Cultural differences o high levels of integration require greater cultural blending o cultural blending may be a matter of:  combining elements of both cultures  essentially replacing one culture with the other o integration may be very costly, often unanticipated o the ability to integrate efficiently may be a source of competitive advantage y Government Policy o governments may constrain ownership by foreign firms o governments may restrict repatriation of profits o government labor policy may limit a firm s ability to apply management practices to target firm

Summary y M&A activity is a mode of entry for vertical integration and diversification strategies y A firm s M&A strategy should satisfy the logic of corporate level strategy y M&A activity can create economic value at announcement, but target firms usually capture that value y M&A activity can create value over the long term for the acquiring firm

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International Issues y Social orientation relative importance of individual and group interests Individualism --------------------------------------------------------- Collectivism o Individualism individual interest dominate:  Firm has individually oriented compensation policies  Employees must make quick decisions on their own o Collectivism group interests dominate:  Firm has group-based compensation policies  Employees who consult with others before making decisions y Power orientation basis on which power and authority are granted to others Respect --------------------------------------------------------------------- Tolerance o Power Respect authority determined by a person s position in a firm  Employees do what they are told  Employees are deferential to senior managers o Power Tolerance authority is determined by its perceived correctness  Employees what to hear justifications before they do what they are told  Employees may or may not be differential depending on how effective senior management have been in the past y Uncertainty orientation Acceptance ---------------------------------------------------------------- Avoidance o Uncertainty Acceptance change and new opportunities are valued  Employees are encourages to think outside of the box  Employees understand that failure sometimes accompanies risk-taking o Uncertainty Avoidance change and new opportunities are not valued  Employees are encouraged to reinforce the boundaries of the box  Employees punish risk-takers for being foolish y Goal orientation Aggressive ---------------------------------------------------------------------- Passive o Aggressive Goal Behavior value material possessions  Employees are willing to work long hours to accomplish objectives  Employees look for tangible results from their work o Passive Goal Behavior value quality of life and welfare of others  Employees will leave when work begins to interfere with the quality of life  Employees are interested in how others in the firm are faring y Time orientation Long-term ------------------------------------------------------------------- Short-term o Long-Term Outlook value patience, determination, and hard work  Employees have long-term goals and objectives  Employees focus on benefits of hard work o Short-Term Outlook tend to focus on the present or past  Employees tend to be satisfied with the status quo  Employees focus on the benefits of traditional ways of doing things

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Research Made Relevant y Managers in potential target firms can respond to takeover attempts in a number of ways to either increase the wealth of the target firm shareholders, have no impact, or decrease the wealth y The wealth effects of target firm management responses to acquisition efforts: o Reduce wealth of target firm equity holders:  Greenmail a maneuver in which a target firm s management purchases any of the target firm s stock owned by a bidder and does so for a price that is greater than the current market value of that stock y No economic value that could have occurred from acquisition plus the cost of the price of the stock  Standstill agreements- a contract between a target and a bidding firm wherein the bidding firm agrees not to attempt to take over the target for some period of time y Forgo any value that could have been created if the acquisition would have occurred and reduces the number of bidders  Poison pills- a variety of actions that a target firm can take to make the acquisition expensive o Responses that do not affect the wealth of target firm equity holders:  Shark Repellents a variety of relatively minor corporate governance changes that are supposed to make it somewhat more difficult to acquire a target firm  Pac man defense fend off an acquisition by taking over the firm or firms bidding for them  Crown jewel sale sometimes a bidding firm is interested in just a few of the businesses currently being operated in the target firm, to prevent an acquisition, the target firm can sell the crown jewels  Lawsuits o Increase the wealth of target firm equity holders:  Search for the white knight another bidding firm that agrees to acquire a particular target in the place of the original bidding firm  Creation of bidding auctions  Golden parachutes a compensation arrangement between a firm and its senior management team that promises these individuals a substantial cash payment if their firm is acquired and they lose their jobs in the process

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