CHAPTER 2STRATEGY AND CAPITAL ALLOCATION

Concept of strategy Grand strategy Diversification debate Portfolio strategy Business level strategy Strategic planning and capital budgetingOUTLINE

Concept of Strategy

Chandler defined strategy as the determination of the basic long-term goals and objectives of an enterprise, and the adoption of courses of action and the allocation of resources necessary for carrying out the goals. Strategy involves matching a firms strengths and weaknesses with the opportunities and threats present in the external environment.

Formulation of StrategiesEnvironmental Analysis

CustomersCompetitorsSuppliersRegulationInfrastructureSocial/political environmentInternal Analysis

Technical know-howManufacturing capacityMarketing and distribution capabilityLogisticsFinancial resourcesOpportunities and threats

Identify opportunitiesStrengths and weaknesses

Determine core capabilities Find the fit between core capabilities and external opportunitiesFirms strategies

DiversificationGrand Strategy

GrowthContractionStability

ConcentrationVertical integration

LiquidationDivestitureThe Thrust of Grand Strategy

Strategies, Principal Motivations, and Likely Outcomes Principal Likely Outcomes Strategy Motivations Profitability Growth Risk Concentration- Ability to serve a High Moderate Moderate growing market - Familiarity with technology and market- Cost leadership Vertical integration- Greater stability for existing High Moderate Moderate and proposed operations - Greater market power Concentric - Improves utilisation of High Moderate Moderate diversification resources Conglomerate- Limited scope in the present Moderate High Low diversification business Stability - Satisfaction with status quo High Low Low Divestment- Inadequate profit High Low Low - Poor strategy

AB(A+B)ROIDiversification DebatePros and Cons Reduces overall risk exposure Expands opportunities for growth Dampens profitability Diversification and Risk Reduction

Why Conglomerates Can Add Value in Emerging MarketsKhanna and Palepu believe that while focus makes eminent sense in the west, conglomerates have certain advantages in emerging markets which are characterised by institutional weaknesses in the following areas : Product markets Capital markets Labour markets Regulation Contract enforcement

Diversification and Value Creation

Market FailureForm of DiversificationSource of Value AdditionCapital marketsUnrelated diversificationGovernance economiesProduct marketsVertical integrationCoordination economiesResource marketsRelated diversificationScope economiesRisk marketsStrategic diversificationOption economies

Diversification A Mixed Bag

PositivesNegatives Managerial economies of scale Dissipation of managerial focus Higher debt capacity Unprofitable investment. Lower tax burden Larger internal capital

Compulsions for Conglomerate Diversification in India

Restriction in growth in the existing line of business, often arising from governmental refusal to expansion proposals. Vulnerability to changes in governmental policies with respect to imports, duties, pricing, and reservations. Opening up of newer areas of investments in the wake of liberalisation. Cyclicality of the main line of business leading to wide fluctuations in sales and profits from year to year. Bandwagon mentality which has been induced by years of close regulation of industrial activity. Desire to avail of tax incentives mainly in the form of investment allowance and large initial depreciation write-offs. A self-image of venturesomeness and versatility prodding companies to prove themselves in newer fields. A need to widen future options by entering newly emerging industries where the potential seems enormous.

How to Reduce the Risks in Diversification

Markides argues that the risk of diversification can be mitigated if managers address the following questions:

What can our company do better than any of its competitors in its current market? What strategic assets do we need in order to succeed in the new market? Can we catch up to or leapfrog competitors at their own game? Will diversification break up strategic assets that need to be kept together? Will we simply be a player in the new market or will we emerge a winner?What can our company learn by diversifying and are we sufficiently organised to learn it?

Guidelines for Conglomerate Diversification

1.If you lack financial sinews to sustain the new project during the learning period, avoid grandiose diversification projects.2. Realistically examine whether you have the critical skills and resources to succeed in the new line of business.3.Ensure that the diversification project has a good fit in terms of technology and market with the existing business.4.Try to be the first or a very early entrant in the field you are diversifying into. This will protect you from serious competitive threat in the initial years.5.Where possible adopt the following sequence: marketing substantial sub-contracting full blown manufacturing.6.Seek partnership of other firms in areas where you are vulnerable or competitively weak.7.If the failure of the new project can threaten the companys existence, float a separate company to handle the new project.8.Remember that meaningful conglomerate diversification represents the greatest challenge to corporate vision and leadership.9.Guard against bandwagon mentality and empire-building tendencies.

Portfolio Strategy

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 of strategic planning and resource allocation. Three such tools are the BCG matrix, the General Electrics stoplight matrix, and the Mckinsey matrix.

BCG Matrix

HighLowLowHighMarket

Growth

RateStarsQuestion MarksCashCows

Dogs

Market Share

Pattern of Capital Allocation

Stars Question marks

Cash cows Dogs on divestment(funds generated) (funds released)

Stars Question marks1 Cash cows Dogs

Part APart B

General Electrics Stoplight Matrix Business StrengthHighMediumLowAttractivenessIndustry

InvestInvestHoldDivestHoldInvestHoldDivestDivest Strong Average Weak

McKinsey Matrix

Very similar to the General Electric Matrix, the McKinsey matrix has two dimensions, viz competitive position and industry attractiveness. The criteria or factors used for judging industry attractiveness and competitive position along with suggested weights for them are as follows:

Assessment of the SBU Factory Automation

AttractivenessIndustryThe McKinsey MatrixCompetitive Position

Market-Activated Corporate Strategy (MACS) Framework

Source: McKinsey & Company

How the Corporate Centre Can Add Value*According to Tom Copeland, Tim Koller, and Jack Murrin, the corporate centre in a multibusiness 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.* Adapted from Tom Copeland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of Companies, New York: John Wiley and Sons, 2000, P.94

Portfolio Configuration

Identifying the appropriate configuration of business portfolio is perhaps the most important task of top management. It calls for an insightful assessment of the logic of relatedness among various businesses in the portfolio. According to C.K. Prahalad and Yves Doz there are different ways of thinking about relatedness: Business selection Parenting similarities Core competencies Interbusiness linkages Complex strategic integration

Barriers to Effective Corporate Portfolio Management - 1

Corporate portfolio management perhaps has the greatest impact on value creation. Despite its significance, many companies do not manage their business portfolios optimal. Three major barriers to effective corporate portfolio management are: Measurement and information problems Behavioural factors Corporate governance and incentives

Barriers to Effective Corporate Portfolio Management - 2

Measurement and information problems Assuming that the growth pattern of a business is an S curve, the slope at any point of the S curve may be regarded as a proxy for the expected return from that point on. The practical problem, of course, is that it is very difficult to establish that you are at an inflexion point. Behavioural Factors Sunk cost thinking Loss aversion Endowment effect Status quo bias Corporate governance and incentives Despite understanding the logic of shareholder wealth maximization, many corporate boards and senior managements commit to other objectives.

Enhancing the Effectiveness of Corporate Portfolio Management

Create a team of independent people for portfolio review.

Improve the quality of information.

Develop processes for thinking about alternatives.

4. Look outside the company.

Business Level Strategies

Diversified firms dont compete at the corporate level. Rather, a business unit of one firm competes with a business unit of another. Among the various models that have been used as frameworks for developing a business level strategy, the Porters generic model is perhaps the most popular According to Porter, there are three generic strategies that can be adopted at the business unit level. Cost leadership Differentiation Focus

Strategy of Cost Leadership: Dell Computer Corporation

Direct selling Built-to-order manufacturing Low cost service Negative working capital

Sources of Competitive Advantage:

Unique Value as Lowest Cost Perceived by Customer

Broad (industry-wide) Strategic Scope

Narrow (segment only)

Overall Overall CostDifferentiation Leadership

Focused Focused CostDifferentiation LeadershipPorters Generic Competitive Strategies

Network Effect Strategy Network effect: The value of a product or service increases as more and

more people use it. Network strategy: Success with the network strategy depends on the ability

of a company to lead the charge and establish a dominant position. eBay Microsoft Richard Luecke: Thus since, most PCs operated with Windows, most new

software was developed for Windows machines. And because most software was Windows-based, more people bought PCs equipped with the Windows operating system. To date no one has broken this virtuous circle.

Strategic Planning and Capital Budgeting

COSTLEADERSHIPAggressiveFOCUS

ConservativeDefensive

GAMESMAN- SHIP Competitive

DIFFEREN- TIATIONFSESCAISConcentric DiversificationConcentrationVerticalIntegrationConcentricMergerConglomerate MergerTurnaroundStatus QuoConglomerateDiversificationDiversificationDivestmentLiquidationRetrenchmentGeneric Strategies and Key Options

SUMMARY

Capital budgeting is not the exclusive domain of financial analysts and accountants. Rather, it is a multifunctional task linked to a firms 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 worthwhileness. Strategy involves matching a firms strengths and weaknesses its distinctive competencies with the opportunities and threats present in the external environment. 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 western economies, corporate strategists have argued from the 1980s that the days of conglomerates are over and have preached the virtues of core competence and focus. Many conglomerates created in the 1960s and 1970s have been dismantled and restructured. Tarun Khanna and Krishna Palepu, however, believe that while focus makes eminent sense in the west, conglomerates may have certain advantages in emerging markets which are characterised by many institutional shortcomings. 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 of strategic planning and resource allocation. Three such tools are the BCG matrix, the General Electrics stoplight matrix , and the Mckinsey matrix.

Diversified firms dont compete at the corporate level. Rather, a business unit of one firm competes with a business unit of another. Among the various models that can be used as frameworks for developing a business level strategy, the Porters 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.