et zc414-l2.pdf

BITS Pilani Hyderabad Campus

Course No. ET ZC414 Project Appraisal

S. Hanumantharao Session 2 Date : 1/11/2015 Total ppt :33

BITS Pilani Hyderabad Campus

Chapter 2 Strategy and resource allocation

BITS Pilani, Hyderabad Campus

1. How strategies are formulated.

2. Different types of strategies.

3. How conglomerates can add value.

4. Tools of portfolio planning.

5. How the corporate centre can add value.

6. Ways in which businesses compete.

Objectives


If you look at any organization today what you see is mainly

the result of capital allocation decisions made in the past.

Its strategic assets, tangible or intangible, are traceable to the

investment decisions of yesteryears.

Companies generally elect one of three common strategic

postures -- shaping the future, adapting to the future or

reserving the right to play.

The resource allocation framework of the firm, which shapes,

guides, and circumscribes individual project decisions,

addresses two key issues

What should be the strategic posture of the firm ?

What pattern of resource allocation sub serves the chosen strategic

posture ?.

Introduction


The objective of maximizing the wealth of shareholders

is reflected, at the operational level, in three key criteria :

profitability, risk, and growth.

1. Profitability : Profitability reflects the relationship between

profit and investment. Profitability = Profit after tax/Net Worth.

2. Risk :- It reflects variability. How much do individual outcomes

deviate from the expected value ?

3. Growth :- This is manifested in the increase of revenue,

assets, net worth, profits, dividends, and so on. To reflect the

growth of a variable, the measure commonly employed is the

compound rate of growth.

Key criteria


Formulation of Strategies


The building blocks of the corporate resource allocation

strategy are the following elementary investment

strategies :

Replacement and modernisation

Capacity expansion

Vertical integration

Concentric diversification

Conglomerate diversification

Divestment

Elementary Investment Strategies


Overall or Grand Strategy

Growth Stability Contraction

Concentration

Vertical Integration

Diversification

Liquidation Divesture

Growth in market size/product range or mkt share

Backward or forward

New Business

Concentric or related

Conglomerate or unrelated

core competencies and capabilities

manufacturing facilities

distribution network

ITC Hotels limited growth opportunities in the existing line of business; emerging and promising sectors, risk reduction


Enlarging the production portfolio by adding new products with the aim of fully utilizing the potential of the existing technologies and marketing system.

Growth through related diversification can create value for shareholders, thanks to the following factors: Managerial Economies of Scale diversification can utilize

managerial talent more effectively.

Higher Debt Capacity because of the coinsurance effect, a diversified company has a higher debt capacity than a focused company.

Lower Tax Burden by combining businesses that have imperfectly correlated cash flows, a diversified firm can avail of tax shelters better.

Concentric Diversification


is moving to new products or services that have no

technological or commercial relation with current

products, equipment, distribution channels, but which

may appeal to new groups of customers.

The major motive behind this kind of diversification is the

high return on investments in the new industry.

Furthermore, the decision to go for this kind of

diversification can lead to additional opportunities

indirectly related to further developing the main company

business - access to new technologies, opportunities for

strategic partnerships, etc.

Heterogeneous (conglomerate) diversification


Diversification : Good or Bad

It expands opportunities for growth, typically in emerging Industries Though risky, has immense potential

Dampens average profitability 60s and 70s saw unrelated diversification 80s saw businesses divesting 90s back to diversification

Of course, diversification is not an unmixed blessing. It can lead to erosion of shareholder value on account of the following: Unprofitable Investment can destroy ready availability of surplus cash generated by some businesses may tempt managers to invest in unprofitable (negative NPV) projects.


To guide the process of strategic planning and resource

allocation, several portfolio planning tools have been

developed. Two such tools highly relevant in this context

are :

BCG Product Portfolio Matrix

General Electrics Stoplight Matrix

Portfolio Planning Tools


Stars Product which enjoy a high, market share and a high growth rate are referred to as stars. Question marks Products with high growth potential but low present market share are called question marks. Cash Cows Products which enjoy a relatively high market share but low growth potential are called cash cows. Dogs Products with low markets share and limited growth potential are referred to as dogs.

cash cows generate funds and dogs, if divested, release funds. On the other hand, stars and question marks require further commitment of funds.


General Electric's Stoplight Matrix


Classic approach to business portfolio management, as exemplified by the BCG matrix and the McKinsey matrix, focuses on the overall attractiveness of the industry and the business's competitive position within the industry.

While the classic approach is inherently sound, it suffers from a limitation. It ignores the synergies between different businesses in the firm's portfolio and assumes that the firm is the right owner for all its businesses.

Since different skills are required for managing different businesses, it is necessary to go beyond business positioning and consider whether there is a good fit between the parent and the business unit.

Parenting Advantage


1. Synergies between different businesses in the firm's portfolio

2. A natural parent, compared to other possible owners, can extract more value. Parenting advantage stems from certain core competencies.

3. Most companies have a few core competencies (such as project management, cost management, product development, manufacturing excellence, brand management, performance management, human resources management, and so on).

4. A core competency represents a world class skill or process that gives the company an edge over competitors, creates value, and is durable.

Parenting Advantage


McKinsey and Company recommends a more sophisticated approach to business portfolio management that considers parenting advantage along with the business unit's inherent value creation potential.


The corporate centre in a multi business company or group can add value in the following ways:

Industry Shaper It acts proactively to shape an emerging industry to its advantage.

Deal Maker It spots and executes deals based on its superior insights.

Scarce Asset Allocator It allocates capital and other resources efficiently across different businesses.

Skill Replicator It facilitates the lateral transfer of distinctive resources.

Performance Manager It instills a high performance ethic with appropriate measurement systems and incentive structures.

Talent Agency It attracts, retains, and develops talent.

Growth Asset Allocator It leads innovation in multiple businesses .

How the Corporate Centre Can Add Value


Corporate portfolio management is mainly concerned with

deciding which businesses to own and which businesses to

divest.

Measurement and Information Problems: In theory a firm

should exit a business when the expected rate of return from

continuing the business is less than the cost of capital.

Behavioral factors: Implementation of effective portfolio

management practices is hampered by "sunk cost thinking",

"loss aversion," "endowment, "status quo bias."

Sunk costs are not relevant for decision making. Yet people do

not overlook sunk costs.

Corporate Governance and Incentives: management is

different from shareholders

Effectiveness of Portfolio Management


1. Diversified firms don't compete at the corporate level. Rather, a business unit of one firm competes with a business unit of another.

2. Among the various models that can be used as frameworks for developing a business level strategy, the Porter's generic model is perhaps the most popular.

3. There are three generic strategies that can be adopted at the business unit level: cost leadership, differentiation, and focus.

4. Another strategy that has gained recognition in recent times is the network effect strategy.

5. A strategy of focus involves concentrating on a narrow line of products or a limited market segment. In the selected target market the company seeks to gain a competitive edge through cost leadership (cost focus) or product differentiation (differentiation focus).

A strategy of differentiation focus involves concentrating on a limited market segment wherein the firm can offer a differentiated product based on its innovative capabilities.

Business level strategies


Telephones, first introduced in the US in late 19th century, were not very useful initially.

A person could just talk to few others who had a telephone.

But as more and more homes and offices joined the telephone network, the utility of telephones increased.

This phenomenon referred to as the network effect: the value of a product or service increases as more and more people use it.

Success with the network strategy depends on the ability of a company to lead the charge and establish a dominant position.

Network Effect Strategy


Competitive advantage or value creation


A firm does not achieve and sustain competitive advantage by merely choosing a competitive strategy.

It has to make necessary commitments to develop the required core competencies and structure its value chain efficiently.

Core competencies are the key economic assets or resources of the firm and value chain is the linked set of activities performed to transform inputs into outputs.

The uniqueness of firm's core competencies and its value chain and the extent to which it is difficult for competitors to imitate them determines the sustainability of a firm's competitive advantage.

Achieving and Sustaining Competitive Advantage


Value Chain


Real investment decisions are not made in a vacuum; they are embedded in a companys strategy


Because firms are usually financially constrained, they

must coordinate their investment strategies with their

financing policies.

The synchronization of investment opportunities and

access to funds for investment is the key goal of modern

corporate risk management.

Financially strong firms overinvest in capacity and adopt

aggressive competitive strategies to drive financially

weak companies out of the market.

Interactions between Financing and Investment Decisions


Capital budgeting is not the exclusive domain of financial analysts and accountants.

Rather, it is a multifunctional task linked to a firm's overall strategy .

Capital budgeting may be viewed as a two-stage process. In the first stage promising growth opportunities are identified through the use of strategic planning techniques and in the second stage individual investment proposals are analyzed and evaluated in detail to determine their worth whileness.

Strategy involves matching a firm's capabilities to the opportunities in the external environment.

Summary


The thrust of the overall strategy or 'grand strategy' of the firm may be on growth, stability, or contraction.

Generally, companies strive for growth in revenues, assets, and profits. The important growth strategies are concentration, vertical integration, and diversification.

While growth strategies are most commonly pursued, occasionally firms may pursue a stability strategy.

Contraction is the opposite of growth. It may be effected through divestiture or liquidation.

Conglomerate diversification, or diversification into unrelated areas, is a very popular but highly controversial investment strategy.

Although a good device for reducing risk exposure and widening growth possibilities, conglomerate diversification more often than not tends to dampen average profitability.


In a multi-business firm, allocation of resources across various businesses is a key strategic decision. Portfolio planning tools have been developed to guide the process strategic planning and resource allocation. Three such tools are the BCG matrix, the General Electric's stoplight matrix, and the McKinsey matrix.

Diversified firms don't compete at the corporate level. Rather, a business unit of one competes with a business unit of another.

Among the various models that can be used as frameworks for developing a business level strategy, the Porter's generic model is perhaps the most popular.

According to Michael Porter, there are three generic strategies that can be adopted at the business unit level: cost leadership, differentiation, and focus.

Capital expenditures, particularly the major ones, are supposed to sub serve the strategy of the firm. Hence, the relationship between strategic planning and capital budgeting must be properly recognized.


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