Module 10 - Growth strategy

Question 1

Describe the possible constraints on firm size

Answer 1

Economists sometimes assume that there is a maximum firm size beyond which profits will start to fall. This may be due to:

1. Managerial diseconomies of scale, leading to higher average costs if output exceeds the most efficient level or range of output, although these could possibly be avoided, eg. by a multidivisional organisation.
2. The downward - sloping demand curves that firms typically face, which place a limit on sales (although it may be possible to avoid demand constraints by entering new markets)

Question 2

Explain the relationships between growth and profitability

Answer 2

1. Profitability affects growth: as profits are needed to finance the investment that is necessary to achieve growth.
2. Growth affects profitability: in the short run the extra investment and expenditure needed to finance growth may reduce profits. In the long run, growth will typically increase profits if it leads to:
   - expansion into new markets
   - increased market power
   - greater economies of scale

Question 3

Internal funds

Answer 3

Funds used for business expansion that come from ploughed-back profit.
Retained profits used specifically to fund new investment and growth.

Question 4

Takeover constraint

Answer 4

The effect that the fear of being taken over on a firm’s willingness to undertake projects that reduce distributed profits.

Question 5

Valuation ratio (or price to book ratio)

Answer 5

The ratio of stock market value to book value. The stock market value is an assessment of the firm’s past and anticipated future performance. The book value is a calculation of the current value of the firm’s assets.

The ratio of the stock market value of the firm’s shares to the book value of the firm’s assets. A low valuation ratio may indicate lack of shareholder confidence and a possible takeover target.

Question 6

Describe five factors that may restrict the ability of the firm to grow

Answer 6

1. Financial conditions
   Growth needs to be financed either from internal funds, new share issues, borrowing.
2. Shareholder confidence
   - Takeover constraint
   - Conversely, a lack of new investment and growth may also render a firm susceptible to takeover by a competitor which thinks the firm could be run more efficiently and profitably.
   - Valuation ratio
3. Demand conditions
   A firm is more likely to be profitable, and hence to be able to fund growth, if it operates in a growing market.
4. Managerial conditions
   - The process of managerial expansion, as new managers take time to be incorporated into a cohesive management team.
   - The expertise of its management team , particularly with regard to the growth of a business.
5. Government policy
   Growth may be constrained by government policies on mergers and takeovers, which are an important part of competition policy.

Question 7

Internal expansion

Answer 7

Where a business increase its productive capacity by adding to existing plant or by building a new plant.
Increasing the size of existing operations.

Question 8

External expansion

Answer 8

Where business growth is achieved by merger, takeover, joint venture or an agreement with one or more other firms.

Question 9

Vertical integration

Answer 9

A business growth strategy that involves expanding within an existing market, but at a different stage of production. Vertical integration can be ‘forward’, such as moving into distribution or retail, or ‘backward’, such as expanding into extracting raw materials or producing components.

Question 10

Diversification

Answer 10

A business growth strategy in which a business expands into new markets outside of its current interests.

Question 11

Strategic alliance

Answer 11

Where two firms work together, formally or informally, to achieve a mutually desirable goal.

Question 12

Outline three ways by which internal expansion can be achieved

Answer 12

1. Horizontal expansion
2. Vertical integration
3. Diversification

Question 13

Outline three ways by which external expansion can be achieved

Answer 13

1. Merger
2. Takeover
3. Strategic alliance

Question 14

Horizontal expansion

Answer 14

Involves the firm producing lots of similar products to take advantage of economies of scope and to appeal to different segments of the market.

Question 15

Tapered vertical integration

Answer 15

Where a firm is partially integrated with an earlier stage of production: where it produces some of an input itself and buys some from another firm.

Question 16

Describe five possible motives for growth via vertical integration

Answer 16

1. Greater efficiency (economies of scale) due to:
   - the production economies that may arise from performing complementary stages of production within the same firm.
   - co-ordination economies that result from savings on buying and selling costs, including marketing and advertising.
   - managerial economies from a single source of supervision
   - financial economies, as larger firms may enjoy more bargaining power with suppliers and providers of finance.
2. Reduced uncertainty
   Greater control over production process.
3. Innovation
   Improved communication between component designers and manufacturers.
4. Increased monopoly power
5. Creation of barriers to entry
   Lower average costs that arise from economies of scale and the control of inputs.

Question 17

Give two problems with vertical integration

Answer 17

1. Reduce the firm’s ability to adapt to changing market conditions, as it may be unable to easily change suppliers and/or retailers.
2. Preclude the spreading of risk gained by diversification.

Question 18

Give two possible advantages and one disadvantage of tapered vertical integration

Answer 18

Advantages:

1. The firm enjoys more control over its supply, and has more bargaining power with suppliers, as it has more information concerning the cost of inputs.
2. Less investment is needed compared to full vertical integration and some of the costs and risks of supply are spread.

Disadvantage:
1. Reduced scope for efficiency gains and economies of scale compared to full vertical integration and other suppliers may be tied into a vulnerable position.

Question 19

State three influences of diversification

Answer 19

1. Nature of technology used and possible adaptions
2. Available market opportunities
3. Skills and expertise of management

Question 20

Give three motives for diversification

Answer 20

1. Stability - enables the business to spread risk and be less susceptible to unpredictable changes in a single market
2. Maintaining profitability - by expanding into new and growing markets
3. Maintaining growth - if the current market offers limited prospects for growth

Question 21

Merger

Answer 21

The outcome of a mutual agreement made by two firms to combine their business activities.

Question 22

Takeover or acquisition

Answer 22

Where one business acquires another. A takeover may not necessarily involve mutual agreement between the two parties. In such cases, the takeover might be viewed as ‘hostile’

Question 23

Give three differences between mergers and takeovers

Answer 23

1. A merger is agreed between the two firms, whereas a takeover can be either friendly, if both parties agree to it, or hostile
2. A merger doesn’t require finance, whereas a takeover requires finance to pay for the shares purchased in the target firm.
3. A merger usually leads to the retention of some managers from both firms, whereas a takeover may lead to the dismissal of all of the management of the firm acquired.

Question 24

Distinguish between horizontal, vertical and conglomerate mergers

Answer 24

Horizontal merger: where two firms in the same industry at the same stage of production process merge.
Vertical merger: where two firms in the same industry at different stages of the production process merge.
Conglomerate merger: where two firms in different industries merge.

Question 25

Give six primary and six other motives for mergers and takeovers

Answer 25

Primary:

1. Growth
2. Economies of scale
3. Monopoly power
4. Increased market valuation
5. Reduction in uncertainty
6. Taking advantage of opportunities

Other:

1. Reducing the possibility of takeover
2. Merging with a White Knight firm (a rescuer), as a defence against an unwanted predator
3. Asset stripping, whereby a firm is taken over and the assets sold off for a profit
4. Empire building
5. Geographical expansion
6. Reducing levels of taxation

Question 26

Give five reasons why mergers do not always bring the anticipated gains

Answer 26

1. Failure to highlight critical issues before the merger
2. Overestimation of synergies, eg cost reductions, revenue increases
3. Failure to recognise insufficient strategic fit
4. Failure to asses cultural fit
5. Problems integrating management teams and retaining staff

Question 27

Joint venture

Answer 27

Where two or more firms set up and jointly own a new independent firm

Question 28

Franchise

Answer 28

A formal agreement whereby a company uses another company to produce or sell some or all of its product.

Question 29

Licencing

Answer 29

Where the owner of a patented product allows another firm to produce it for a fee.

Question 30

Consortium

Answer 30

Where two or more firms work together on a specific project and create a separate company to run the project.

Question 31

Out-sourcing or subcontracting

Answer 31

Where a firm employs another firm to produce part of its output or some of its inputs.

Question 32

Vertical restraints

Answer 32

Where a dealer is restrained by a manufacturer as to how and where it can sell a product.

Question 33

Network

Answer 33

The establishment of formal and informal multi-firm alliances across sectors.

Question 34

Distinguish between horizontal and vertical strategic alliances

Answer 34

Horizontal strategic alliances are agreements to co-operate on a particular activity at the same stage of the production process.

• joint venture
• franchise
• licencing

Vertical strategic alliances are agreements between firms at different stages of the same production process to jointly produce a good or service. These alliances may help manage the supply of inputs to a firm and the outputs to the customers.

• consortium
• outsourcing or subcontracting
• vertical restraints

Question 35

Give four reasons for forming strategic alliances

Answer 35

1. New markets
2. Risk sharing
3. Capital pooling
4. Cost
5. Experience

Question 36

Minimum efficient scale (MES)

Answer 36

The size of the individual factory of of the whole firm, beyond which no significant additional economies of scale can be gained. For an individual factory the MES is known as the minimum efficient plant size (MEPS)

Question 37

Explain the transactions cost approach to explaining external growth of the firm

Answer 37

Mergers or strategic alliances may be appropriate where there are large sunk costs and uncertain transaction costs between firms eg between a producer and its supplier of components of raw materials. They can lead to greater co-operation between the parties involved and also reduce the chances of opportunitstic behaviour by one against the other arising from information assymetry.