chapter 2 market imperfections and value: strategy matters

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Chapter 2

Market Imperfections and Value:Strategy Matters

DR. IBRAHEM AL-EZZEE-FIN421CHAPTER2

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Strategy sets the general direction of the organization and provides the framework within which capital investment opportunities are sought.

The major focus of strategy is the generation of wealth through creation and use of competitive advantage.

Competitive advantage is a departure from perfect competition that it makes it possible to earn an economic profit


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Perfect product or services marketshave the following characteristics:

No restrictions on entry and exitNo producers so large that they have price

influenceAll producers manufacture identical productsAll producers have identical costComplete information about competitors’

actions


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In a competitive environment business can just barely satisfy investors and earn an economic profit of zero.

Businesses can go beyond survival to create wealth if they can avoid significant aspects of market perfection.


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Competitive Advantage CA. Is a departure from perfect competition that makes it possible to earn an economic Profit.The key considerations necessary forcompetitive advantage are:a. Industry characteristicsb. Product differentiationc. Cost advantage


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a. Industry Characteristics Barriers to entry exist Customers are not price sensitive Customers are not fully informed Demand is stable Competitors are limitedb. Product Differentiation Features: special feature preferred by customers will make

it possible to gain competitive advantage. Quality: Example of Toyota and General Motors. Image: Create image like consuming the product will make

a Hero Service c. Cost Advantage


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Cost AdvantageEconomies of scaleTechnologyCorporate cultureControl of supply of inputs


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Strategic Planning The ultimate goals of strategic planning are competitive advantage and economic profit The strategy of the company defines the business that the company is in and how it intends to position itself within the industry

Strategy Development:1. A statement of goals2. An analysis of the environment3. An analysis of the organization itself


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Goals: Wealth maximization objective need to be translated into concrete goals against which performance can be measured( ROA, ROE or cost/unit)

Analysis of the Environment: Threats & Opportunitiesa. Threats: a threat is any unfavorable situation in the organization's environment that is potentially damaging to the organization and its Strategy.


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b. Opportunities: An opportunity is any favorable situation in theorganization’s Environment that support the demand for a product or service and permits thefirm to enhance its position.

An understanding of the organization’sopportunities and threats help the strategistidentify the company’s most effective niche.


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Analysis of the organizationWhat are our strengths and weaknesses?

a. Strengths: A strength is resource or Capacity the organization can use effectively to achieve its objectives

b. Weaknesses: A weakness is a limitation, fault, or defect in the organization that will keep it from achieving its objectives


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Industry AnalysisAn industry can be defined as a group or groups oforganizations producing similar or identical

products. These organizations also compete for customers to purchase their products and mustsecure the necessary resources (or inputs) that areconverted (or processed) into final products (oroutputs).

Porter’s Five Factors model (page46)


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Threat of new entries: Under what conditions will a new competitor enter a firm’s market. What can a firm do about it?.

Bargaining power of the buyers: In general, the higher the bargaining power of the industry’s buyers possess, the less the advantage the selling firm has.

Bargaining of the suppliers: In general, the greater the power the supplier has, the less advantage the firm has.


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Threat of substitutes : The closer the substitutes the more limited the power of the seller.

Rivalry among existing firms (intensity of rivalry): In general,

a. the more competitors, the greater the rivalry, and

b. The more equivalent the firms are in terms of size, skills, and market power, the greater the rivalry tends to be.


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Aligning Capital Budgeting with Corporate Strategy:Strategy is the foundation of a successful capital

budgeting systemStrategy should guide decisions about where to

look for CIO and which investments are most likely to have positive NPVs.

Successful capital budgeting and wealth maximization are therefore dependent on sound strategy.


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Capita Budgeting Pitfalls Bias against strategically important CIsa. Favoring replacement decisionsb. Undue focus on short-term results (short payback period)c. A narrow or shortsighted view-ignoring the value of future IO that may be created by

the investment currently under consideration.d. Investing in growth for growth’s sake.


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Failure to give up is another barrier to strategy implementation.

Allocating capital among divisions according to past profitability is another potential detriment.

Capital investment analysis ignoring market dynamics is another blow implementation of strategy.

Compensation system must be based on longer-term profitability.


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Financial Decisions and Strategy

Capital investment policy (CIP): CIP must be designed to assure that the investment chosen will contribute to the corporation’s strategyCapital structure policy (CSP): Choosing the financing mix that will minimize the cost of capital and maximize the value of the business


chapter 2 market imperfections and value: strategy matters

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