Chapter 10: Corporate Governance 315Lockheed Martin’s new CEO in 2013, Marillyn Hewson, is tasked with charting a future
for the company that likely includes diversification. The firm’s Center for Innovation is
working on several potential products and services in the health care and cybersecurity
industries. So, it appears that it will try to diversify organically by developing innovations
internally (using its current capabilities) rather than acquiring other firms as it did in
the past. In fact, Hewson describes Lockheed Martin as a global security enterprise, sug-
gesting its new focus and vision. While previous diversification efforts were unsuccessful,
Lockheed Martin is trying again with a new CEO and emphasis on internal innovation
and international expansion.^31
Free cash flow is the source of another potential agency problem. Calculated as oper-
ating cash flow minus capital expenditures, free cash flow represents the cash remaining
after the firm has invested in all projects that have positive net present value within its
current businesses.^32 Top-level managers may decide to invest free cash flow in product
lines that are not associated with the firm’s current lines of business to increase the firm’s
degree of diversification (as is currently being done at Lockheed Martin). However, when
managers use free cash flow to diversify the firm in ways that do not have a strong pos-
sibility of creating additional value for stakeholders and certainly for shareholders, the
firm is overdiversified. Overdiversification is an example of self-serving and opportunistic
managerial behavior. In contrast to managers, shareholders may prefer that free cash flow
be distributed to them as dividends, so they can control how the cash is invested.^33
In Figure 10.2, Curve S shows shareholders’ optimal level of diversification. As the
firm’s owners, shareholders seek the level of diversification that reduces the risk of the
firm’s total failure while simultaneously increasing its value by developing economies
of scale and scope (see Chapter 6). Of the four corporate-level diversification strategies
shown in Figure 10.2, shareholders likely prefer the diversified position noted by point
A on Curve S—a position that is located between the dominant business and related-
constrained diversification strategies. Of course, the optimum level of diversification
Figure 10.2 Manager and Shareholder Risk and DiversificationRiskDominant
businessRelated-
constrainedRelated-
linkedUnrelated
businessesABS
MShareholder
(business)
risk profileManagerial
(employment)
risk profileDiversification