Session 9: The boundaries of the firm II: Applications Flashcards
ZHOU (2011): Focus of the paper
Dives into synergies, diversification, and related diversification, but also the dark side of diversification (Increased coordination costs)
ZHOU (2011): Views on diversification
Corporate finance on diversification: The result of value-destroying managerial moral hazard (free cash flows are put into empire building).
Markets also suspicious: The “diversification discount”, shares of diversified firms sell at a discount.
TOF: However, the ToF suggests that diversification may be value-increasing: Firms tend to accumulate excess resources (managerial know-how, learning by doing, etc.); strong incentive to monetize these (0 opportunity costs); when market contracts, hybrids fail and firms beat markets Related diversification
So, not managerial moral hazard, but superior knowledge of how to use (excess) resources
ZHOU (2011): Diversification and synergies
Synergistic view: Prescribes a continuous path for diversification: a firm will start with the most related industries, expand through progressively less related industries, and stop when potential synergy diminishes to zero.
* Diminishing synergistic benefits limit diversification in general
Diversification: Can represent a mechanism for capturing integration economies associated with the simultaneous supply of inputs common to a number of production processes geared to distinct final product markets.
ZHOU (2011): Coordination costs
Coordination costs: Diversification merely shifts transaction costs into the boundary of the firm as coordination costs, because sharing common inputs creates interdependencies between business lines. Interdependencies challenge three elements of coordination:
* Communication
* Information processing
* Joint decision making
Increasing coordination costs moderate the impact of synergy on the choice of industries and set a limit to related diversification
ZHOU (2011): Related diversification
Related diversification can be justified by synergies that arise from sharing inputs
* To realize this synergy, a firm needs to actively manage the interdependencies between different business lines, which, in turn, increases its coordination costs
Coordination costs in related diversification: Coordination costs are greater for firms pursuing more related diversification due to more interdependencies.
* Coordination costs go up more than linearly with the number of business lines; they increase with the amount of interdependencies among them.
* The difference in marginal coordination costs between more and less related diversification may become greater than the difference in marginal synergistic benefits between the two Diversification into a less related business becomes more attractive than a more related business.
Managing the related-diversified firm: Diversification arises as a response to market failure… but risks shifting transaction costs into the boundary of the firm
ZHOU (2011): Complexity
Complexity: However, there is a dark side to related diversification: it involves more interdependencies / complexity (Departmentalization and interdependencies) more costly to manage
ZHOU (2011): Hypotheses
H1: Complexity: Firms with high complexity in its existing business lines are less likely to engage in new diversification moves
H2: Interdependencies: This effect is reinforced when the new business shares more inputs with the existing business lines (as complexity is then further increased)
ZHOU (2011): Alternative motivations for diversification choices
Leverage ratio: Portfolio theory predicts that a higher leverage ratio implies greater risk and will be correlated with more diversification, especially unrelated diversification. However, AT predicts that it will lead to higher supervision by lenders and thus less diversification
External supervision: Consistent with the agency theory than portfolio theory, the results show that firms that are more ‘disciplined’ by external investors are less likely to diversify in general, but prefer more related industries if they do diversify
Leader-follower effect: Consistent with prior research, firms do tend to follow large and successful firms when diversifying into other industries, especially less related industries
Vertical relatedness: Vertical relatedness is positively associated with the probability of entry, consistent with both asset-specificity and market-power explanations for vertical integration
ZHOU (2011): Conclusions
- The similarity of inputs (a source of synergy) between a firm’s business lines and a target business increases the probability that the firm diversifies into the target business, but the firm is less likely to diversify into any new business when it has greater complexity (a source of coordination costs) in its existing business lines.
- Importantly, the potential for input sharing magnifies the negative impact of complexity on entry.
- These results confirm that coordination costs are an important explanation for limits to related diversification (relative to unrelated diversification) that is independent of existing explanations such as risk pooling, agency, and imitation.
Kafuman & Lafontaine (1994): Focus of the paper
Objective: To show that there are important amounts of downstream rents, both ex post and ex ante, at McDonald’s. There are ex ante rents is especially interesting given that most incentive-based theories of franchising predict that there should not be such rents.
Kafuman & Lafontaine (1994): Franchising
Franchising: Is a part of the hybrid organizational form (partly hierarchy and partly market)
* Market mechanism: Represented by the profit mechanism –> The franchisee works for his own profits (He is a residual claimant)
* Hierarchy mechanism: There are rules to follow from the HQ and the mother company usually owns a share of the franchise’s profits
Kafuman & Lafontaine (1994): Why franchising?
Agency problem: Franchising when there is geographical distance between producer, distributor monitoring the input performance of distributor is costly
Delegation: Each party (franchisor, franchisee) specialize (development, marketing, production, distribution); (constrained) delegation makes sense
Efficiency: By making franchisees residual claimants, franchising contracts provide incentives for franchisees to pick efficient actions
Additional problem: Incentives for the franchisee to reduce quality to freeride on the brand/trademark; additional safeguards are required (discussed in K&L, McDonalds case)
Kafuman & Lafontaine (1994): The franchise structure of McDonalds
Owned: Each area supervisor at McOpCo (Operation Company) oversees the operations of an average of four company-owned stores, with a maximum of six.
Franchise: On the franchised side of the company, the equivalent “field consultants” are responsible for an average of nine franchisees, who on average control 21 restaurants.
Kafuman & Lafontaine (1994): Puzzles presented in the article
- Why isn’t the price (franchise fee) regulated such that the franchisee only gets ε more than her opportunity cost? I.e., why are rents left downstream (when demand for becoming a franchisee is high: Many on waitlist to become franchisee)?
- Why are there royalty payments (when all payments from the franchisee to the franchisor could be concentrated in the franchise fee)?
- Why is there dual distribution? (Both franchises and wholly owned shops)
Kafuman & Lafontaine (1994): Conclusion on puzzle one
It does make sense to pay rents downstream. Why?
* Creating additional incentives/safeguards: if you are caught, e.g., manipulating product quality and are terminated, you really lose out. I.e., you are incentivized to choose efficient actions
* McDonalds wants people whose livelihoods are tied to the success of their outlets; they are likely to be liquidity-constrained
Bargaining power: So, McDonalds has a lot of bargaining power; how come this doesn’t become manifest in franchisor opportunism (e.g., McDonalds supplying less advice, assistance, maintenance of the trademark etc.)?
