The firm’s desire to expand is generally driven by the underlying economics of the business. Firms will expand beyond the “local” market to take advantage of strong demand in other geographies. Firms with significant product penetration in the local market will look to expand into other domestic and/or international markets in an attempt to continue to drive revenue growth. Also, companies expand to diversify and minimize risk.
Business in different geographic locales, especially different nations, will likely vary based on local economic conditions. For example, business in the United States may be booming, while in Germany it may be soft.
When firms expand, they must make decisions about these questions:
- Where to expand: Domestic or international?
- What to expand: Which product lines do we expand or expand into?
- How to expand: Expansion via acquisition or with our own products?
Of course, expansion requires capital. Companies differ in how they raise the required capital. Some firms use debt, others use equity, and some can rely on internal cash generation.
Where to expand?
The general model of business expansion has been to expand in the domestic region first, then the entire domestic market, and finally, the international market. When looking at geographic expansion, firms analyze the demand for their product(s) in the prospective market; they also analyze local economic conditions, competition, and the incremental cost to serve the new market.
Expanding internationally is much riskier than domestic expansion because the issues that must be addressed add complexity. In international expansion, firms must take into account and understand the political environment in the expansion market, the labor and tax laws, the local customs and attitudes about foreign companies, and the management of currency risk.
However, domestic expansion is not without its challenges as well. Distribution networks must be established, labor laws vary from state to Firm Expansion state, and possible competitive response must be weighed.
What to expand?
It is critical to understand the microeconomic concepts of demand and own price elasticity with respect to expanding the product line. When strong demand exists for a product, it should be expanded aggressively but wisely. Firms usually do not create a new facility and expand a product into new markets except in those cases where demand is very strong and likely to be for some considerable time (Phatak, Bhagat, & Kashlak, 2009).
When it comes to what product line(s) to expand and how to price it (them), firms must appreciate own price elasticity and cross price elasticity. Products with strong demand are likely to have a low own price elasticity and can be priced more aggressively. Products with few substitutes (reflected in a low cross price elasticity) can be priced more aggressively as well.
How to expand?
The “how” of expansion generally follows the approach of either expanding with “internal resources” (the company’s existing product lines and/or research and development (R & D) for new product development) or with “external resources” via acquisition.
Companies can pursue an “internal resource” approach if there is sufficient time to expand the product line and/or to develop a new product through research and development (R & D). However, if the market is changing quickly and competition is likely to respond swiftly, managers typically pursue an acquisition strategy of acquiring similar products in new markets, acquiring adjacent products in existing/new markets, or a combination of both (Keat, Young, & Erfle, 2014).
Expansion, Risk, and Firm Valuation
As noted, expansion requires capital and entails a certain level of risk. Furthermore, expansion does have an impact on firm valuation. How a company raises the capital for an expansion will be determined by the structure of the firm’s balance sheet. Highly levered firms will have a difficult time raising debt and are likely to struggle raising equity. On the other hand, firms with strong cash positions on their balance sheet may be able to finance Firm Expansion their expansions out of cash flow.
Beyond the risk outlined above, companies incur financial risk when they expand. Additional debt raises the risk of default or raises the firm’s cost of debt. Raising equity dilutes the equity of existing shareholders, and cash used for expansion cannot be used for other activities—such as paying off debt or increasing the dividend paid to shareholders.
Ultimately, the value of the firm will either rise or fall when an expansion occurs. Expansions that the market perceives as creating value for the firm will increase a company’s stock price. Those expansions that are seen as extremely risky and adding very little value are likely to drive a company’s stock down.
Be smart and be encouraged,
Keat, P. G., Young, P. K. Y., & Erfle, S. E. (2014). Managerial economics: Economic tools for today’s decision makers. (7th ed.). Upper Saddle River, NJ: Prentice Hall
Phatak, A. V., Bhagat, R. S., & Kashlak, R. J. (2009). International management. Managing in a diverse dynamic global environment. (2nd ed.). New York, NY: McGraw-Hill.