Corporate Strategy Diversification - Prof. Dr. Bernd Venohr

Remarks-Theory of unrelated diversification:
Why an internal capital market can be more efficient
than the external capital market?
� Create value by exploiting financial economies: large organizations can fund
projects more quickly and economically than external market
– small projects are bundled, large company can borrow more cheaply (company as
securitized bundle of projects)
– large projects: diversified firm may take on projects whose risk is too great to be
taken on by any one or a group of smaller companies
– key challenge for related diversifiers: find products and markets that can take
advantage of competitive strengths but at the same time provide negatively
correlated cash flows
� Reduce funding costs through superior financial resource allocation: internal
capital market is like a debt market with all the benefits of equity ownership
– resolve borrower-lender problem (“moral hazard”): once lending contract is signed
borrower has an incentive to increase risk of project financed increasing his
expected return while decreasing that of a lender. Contracts can only imperfectly
control this risk
– internal funding allows for information sharing and better control over the use of
funds by the “lender”
– less likely that borrower and lender expropriate each other
Source: Corey Phelps; Mgmt 430
© 2006 Dr. Bernd Venohr
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