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Discuss three reasons why the corporate profits of a diversified firm may be an unsuitable measure of the firm's competitive advantage
Porter suggests three 'essential tests' to be applied in deciding whether diversification will truly create shareholder value.
Attractiveness test and cost of entry test
The industries chosen for diversification must be structurally attractive or capable of being made attractive. The challenge of entering the new industry and high cost of entry recognises that for outsiders the cost of entry may counteract the attractiveness of the industry.
Cost of entry must capitalise all future profits. Barriers and cost of entry a pharmaceutical industry, for example, may be too high.
Better of test
The cost of entry must not capitalise all future profits. If two businesses producing different products are brought together under the ownership and control of single enterprise, is there any reason why it should become more profitable? Circumstances where operating multiple businesses create value: economies of scope and presence of transaction costs). However, attractiveness test and better off test can cancel each other since industries tend to be attractive because they are difficult to enter. The opposite might be true. It can enter an unattractive industry as long as the cost of entry is sufficiently discounted and the better-off test is met.
Porter Three 'essential tests'
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Resources and capabilities
Industry life cycle
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CHAPTER 8 - KEY POINTS
Multiple choice // 2015