188 Part 2: Strategic Actions: Strategy Formulation
6-5 Value-Neutral Diversification: Incentives and Resources
The objectives firms seek when using related diversification and unrelated diversification
strategies all have the potential to help the firm create value through the corporate-level
strategy. However, these strategies, as well as single- and dominant-business diversifi-
cation strategies, are sometimes used with objectives that are value-neutral. Different
incentives to diversify sometimes exist, and the quality of the firm’s resources may permit
only diversification that is value neutral rather than value creating.6-5a Incentives to Diversify
Incentives to diversify come from both the external environment and a firm’s internal
environment. External incentives include antitrust regulations and tax laws. Internal
incentives include low performance, uncertain future cash flows, and the pursuit of
synergy, and reduction of risk for the firm.Antitrust Regulation and Tax Laws
Government antitrust policies and tax laws provided incentives for U.S. firms to diversify
in the 1960s and 1970s.^82 Antitrust laws prohibiting mergers that created increased mar-
ket power (via either vertical or horizontal integration) were stringently enforced during
that period.^83 Merger activity that produced conglomerate diversification was encouraged
primarily by the Celler-Kefauver Antimerger Act (1950), which discouraged horizontal
and vertical mergers. As a result, many of the mergers during the 1960s and 1970s were
“conglomerate” in character, involving companies pursuing different lines of business.
Between 1973 and 1977, 79.1 percent of all mergers were conglomerate in nature.^84
During the 1980s, antitrust enforcement lessened, resulting in more and larger hori-
zontal mergers (acquisitions of target firms in the same line of business, such as a merger
between two oil companies).^85 In addition, investment bankers became more open to the
kinds of mergers facilitated by regulation changes; as a consequence, takeovers increased
to unprecedented numbers.^86 The conglomerates, or highly diversified firms, of the 1960s
and 1970s became more “focused” in the 1980s and early 1990s as merger constraints were
relaxed and restructuring was implemented.^87
In the beginning of the twenty-first century, antitrust concerns emerged again with
the large volume of mergers and acquisitions (see Chapter 7).^88 Mergers are now receiving
more scrutiny than they did in the 1980s, 1990s, and the first decade of the 2000s.^89
The tax effects of diversification stem not only from corporate tax changes, but also from
individual tax rates. Some companies (especially mature ones) generate more cash from
their operations than they can reinvest profitably. Some argue that free cash flows (liquid
financial assets for which investments in current businesses are no longer economically
viable) should be redistributed to shareholders as dividends.^90 However, in the 1960s and
1970s, dividends were taxed more heavily than were capital gains. As a result, before 1980,
shareholders preferred that firms use free cash flows to buy and build companies in high-
performance industries. If the firm’s stock value appreciated over the long term, shareholders
might receive a better return on those funds than if the funds had been redistributed as div-
idends because returns from stock sales would be taxed more lightly than would dividends.
Under the 1986 Tax Reform Act, however, the top individual ordinary income tax rate
was reduced from 50 to 28 percent, and the special capital gains tax was changed to treat
capital gains as ordinary income. These changes created an incentive for shareholders to stop
encouraging firms to retain funds for purposes of diversification. These tax law changes also
influenced an increase in divestitures of unrelated business units after 1984. Thus, while indi-
vidual tax rates for capital gains and dividends created a shareholder incentive to increase