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Diversification can be a costly strategy for firms to undertake, and they should only do so if it creates new value for their shareholders. To create value through diversification, managers need to find ways to combine their existing operations with the new business in a way that increases the value of the diversified firm beyond the combined value of the pre-diversified firms.
One way to create value is by lowering costs. Diversified firms can operate in multiple businesses more efficiently than separate firms in each business, leading to economies of scale, leveraging core competencies, sharing activities, and possibly vertical integration. These lower costs enable the firm to generate the same level of total revenue with less expense.
Another way to create value is by increasing revenue. Diversified firms can generate more revenue than separate firms in each business through processes such as pooled negotiating power and vertical integration. Pooled negotiating power can enable the firm to negotiate better deals with suppliers or customers, while vertical integration can enable the firm to capture a larger share of the value chain.
In summary, diversification can create new value for firms if managers are able to combine their operations in a way that leads to lower costs and/or increased revenue beyond what would be possible with separate firms. This can benefit shareholders by increasing the value of the firm.
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