Page 134 - DCOM506_DMGT502_STRATEGIC_MANAGEMENT

Strategic Management

Notes part of turnaround strategy to get rid of businesses that are unprofitable, that require too much
capital or that do not fit well with the firm's other activities.
Divestiture is an appropriate strategy to be pursued under the following circumstances:

1. When a business cannot be turned around
2. When a business needs more resources than the company can provide
3. When a business is responsible for a firm's overall poor performance
4. When a business is a misfit with the rest of the organisation

5. When a large amount of cash is required quickly
6. When government's legal actions threaten the existence of a business.

Reasons for Divestitures

1. Poor fit of a division: When the parent company feels that a particular division within the
company cannot be managed profitably, it may think of selling the division to another
company. This does not mean the division itself is unprofitable. The other firm with
greater expertise in the line of business could manage the division more profitably. This
means the division can be managed better by someone else than the selling company.
2. Reverse synergy: Synergy refers to additional gains that can be derived when two firms
combine. When synergy exists, the combined entity is worth more than the sum of the
parts valued separately. In other words, 2 + 2 = 5. Reverse synergy exists when the parts
are worth more separately than they are within the parent company's corporate structure.
In other words, 2 + 2 = 3. In such a case, an outside bidder might be able to pay more for a
division than what the division is worth to the parent company.
3. Poor performance: Companies may want to divest divisions when they are not sufficiently
profitable. The division may earn a rate of return, which is less than the cost of capital of
the parent company. A division may turn out to be unprofitable due to various reasons
such as increase in the material and labour cost, decline in the demand etc.
4. Capital market factors: A divestiture may also take place because the post divestiture
firm, as well as the divested division, has greater access to capital markets. The combined
capital structure may not help the company to attract the capital from the investors. Some
investors are looking at steel companies and others may be looking for cement companies.
These two groups of investors are not interested in investing in combined company, with
cement and steel businesses due to the cyclical nature of businesses. So each group of
investors are interested in stand-alone cement or steel companies. So divestitures may
provide greater access to capital markets for the two firms as separate companies rather
than the combined corporation.

5. Cash flow factors: Selling a division results in immediate cash inflows. The companies
that are under financial distress or in insolvency may be forced to sell profitable and
valuable divisions to tide over the crisis.
6. To release the managerial talent: Sometime the management may be overburdened with
the management of the conglomerate leading to inefficiency. So they sell one or more
divisions of the company. After the divestiture, the existing management can concentrate
on the remaining businesses and can conduct the business more efficiently.
7. To correct the mistakes committed in investment decisions: Many companies in India
diversified into unrelated areas during the pre-liberalization period. Afterwards they
realised that such a diversification into unrelated areas was a big mistake. To correct the
mistake committed earlier, they had to go for divestiture. This is because they moved into
product market areas with which they had less familiarity than their existing activities.

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