Academic journal article Global Business and Management Research: An International Journal

Does Diversification Influence Systematic Risk and Corporate Performance? an Analytical and Comprehensive Research Outlook

Academic journal article Global Business and Management Research: An International Journal

Does Diversification Influence Systematic Risk and Corporate Performance? an Analytical and Comprehensive Research Outlook

Article excerpt

Introduction and Review

Several evidences suggest that companies diversify when they have valuable and difficult to emulate resources that are valuable across industries, or are complementary to resources in other industries. These gains cannot be realized by contracting among independent companies. Some of the other reason for the companies to diversify is when they have effective internal resource-allocation mechanisms. This happens particularly when background institutions and external capital markets are undeveloped. Theoretical arguments suggest that diversification has both value-enhancing and value-reducing effects. Several school of thought very strongly believe that product diversification have a very positive impact on the corporate profitability in terms of less incentive to forego positive net present value projects, greater debt capacity and lower taxes and economies of scope.

Ansoff (1972) in his seminal work, "A model for diversification" explained different type of expansion strategies like Diversification Strategy, followed by a company. Diversification is a growth strategy which increases earnings, in strenuous industries. A number of studies have hypothesized that diversification improves profitability through economies of scope by pre empting the product space. Montgomery (1994) had also explicitly outlined performance improvement as one of the most important reasons for corporate diversification.

Whereas the counter school of thought is of a very strong opinion that product diversification leads to loss of the unique preposition of the company thus leading to heavy financial losses. Another set of researchers feel that there is no significant impact of implementing diversification strategy on the financial performance of the corporate. So as researcher we need to dig in and check the views of various researchers about the subject in question. The literature on complementarities is thinner than the literature on substitutability. There is growing interest among economists in organizational complementarities Hitt (2002) and James, Klein (2008), but these ideas have not been widely applied to questions of corporate scope. Just as organizational practices, governance, and ownership tend to cluster in particular combinations industry activities may tend to cluster, in ways that cannot be managed effectively across independent companies.

The paper also involves the cross structural linkage of diversification strategy with Capital structure as well as corporate performance. Modigliani and Miller (1958) through their famous research studied capital structure decisions and its impact on profitability, risk profile and overall shareholder value. Empirical evidence shows that a corporate capital structure is influenced by several corporate-related characteristics including size, profitability, future growth options, the amount of tangible assets and non-debt tax-shields Titman and Wessels (1988); Haris and Raviv (1991). Further research by Barton and Gordon (1976) had also suggested the usefulness of the corporate strategy perspective in various perspectives in understanding capital structure. Haris and Raviv (1991) also confirmed that the effect of strategic variables on capital structure is a relatively unexplored area from various angles of research. Alonso (2003) tried to investigate the effect of diversification strategy on corporate capital structure. The researcher however found a non-significant relationship between corporate leverage and the degree of corporate diversification.

However, Abor (2008) compared the capital structure of publically listed companies, large unlisted companies and small and medium enterprises. The study indicates that company size, age, asset structure, profitability, risk and managerial ownership are important in influencing the capital structure decision of Ghanian companies. The result of this study are contrary to the trade off theory Modgilani and Miller (1963) and seem to support packing order hypothesis Myers (1984); Myers and Majluf (1984) shows that both long term and short term debts have inverse relation with company profitability. …

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