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Risk Diversification

Risk Diversification

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Published by ClassOf1.com
Mergers and acquisitions occur for many different reasons, ranging from the desire for risk reduction to the necessity of doing something with extra cash currently held for which the firm has no other special plans. Risk diversification is a difficult objective to evaluate. Individual investors can diversify for themselves.
Mergers and acquisitions occur for many different reasons, ranging from the desire for risk reduction to the necessity of doing something with extra cash currently held for which the firm has no other special plans. Risk diversification is a difficult objective to evaluate. Individual investors can diversify for themselves.

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Published by: ClassOf1.com on Jun 19, 2013
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Finance
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Sub: Finance Topic: Risk Analysis
*
Risk Diversification
Mergers and acquisitions
occur for many different reasons, ranging from the desire for risk reductionto the necessity of doing something with extra cash currently held for which the firm has no otherspecial plans.
Risk diversification
is a difficult objective to evaluate. Individual investors can diversifyfor themselves. A corporation does not have to diversify for its investors.
Mergers and acquisitions
 are generally assumed to reduce risk for the acquiring firm, but this is not necessarily so. If the risk of the acquired firm is sufficiently large, it tends to contaminate the financial position of the firmacquiring it. Paying too much for an acquisition can also advers
ely affect the acquirer’s risk.
Despitethis, certain types of mergers tend to reduce risk. Assume two firms have operations that are perfectlyindependent of each other, both in an economic and statistical sense. In this situation, investors whokeep their investment size the same in a merger will reduce their risk. We are assuming that thefailure of one firm will not cause a failure of the second firm, and that operations are not affected bythe merger.
For example
, say one group of investors owns a firm where there is a
0.5 probability of success
and
0.5 probability of failure
. If that firm is merged with a second firm with the sameprobabilities of success and failure but whose operations are independent, and if the originalinvestors now own 50 percent of the merged firms, there would only be a 0.25 probability of bothportions of the merged firm failing. Hence, in this case, risk has been reduced (the expected returnmay be unchanged).
For simplicity’s sake, we generally assume the goal o
f a firm is profit maximization in order tomaximize the well-being of the common stockholders. We should periodically question thisassumption, since corporations are also in existence to serve other groups,
for example
,management. When a firm diversifies by merging with or acquiring a firm in another industry, whobenefits? Let us consider the position of the shareholder and, for purposes of focusing ondiversification, let us assume zero investor tax rates. The objective of diversification is risk reduction.
 
 
Sub: Finance Topic: Risk Analysis
*
The advice not to p
ut all one’s eggs in one basket
is good advice if the objective is to avoid a feast-or-famine situation. The individual shareholder can diversify easily by buying stocks in different firms indifferent industries or by investing in mutual funds. The stockholder of a company does not need thecompany to incur costs to achieve diversification. If diversification can generally be efficientlyachieved by investors, then why do firms diversify? Naturally, there are many investors who are notwell diversified and would like the corporation to diversify on their behalf. More importantly,management has its major asset invested in the firm, and this asset is difficult to diversify. The majorassets of managers are their careers. If a company goes bankrupt or enters a period of financialdifficulty, the middle-aged manager pays a heavy price. Hence, it is reasonable for such a manager toseek a higher level of security by trying to stabilize the income of the corporation.

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