CHAPTER 2

STRATEGY AND CAPITAL ALLOCATION

OUTLINE
Concept of strategy Grand strategy Diversification debate Portfolio strategy

Business level strategy

Strategic planning and capital budgeting

Concept of Strategy

Chandler defined strategy as the determination of the basic longterm 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 Strategies
Environmental Analysis
Customers Competitors Suppliers Regulation Infrastructure Social/political environment

Internal Analysis
Technical know-how Manufacturing capacity Marketing and distribution capability Logistics Financial resources

Opportunities and threats

Identify opportunities Find the fit between core capabilities and external opportunities Firms strategies

Strengths and weaknesses Determine core capabilities

The Thrust of Grand Strategy

Grand Strategy

Growth

Stability

Contraction

Concentration

Vertical integration

Liquidation

Divestiture

Diversification

Strategies, Principal Motivations, and Likely Outcomes

Principal
Strategy Concentration Motivations - Ability to serve a growing market

Likely Outcomes
Profitability High Growth Moderate Risk Moderate

- Familiarity with technology

and market - Cost leadership Vertical integration - Greater stability for existing and proposed operations High Moderate Moderate

- Greater market power

Concentric diversification Conglomerate - Improves utilisation of resources - Limited scope in the present Moderate High Low High Moderate Moderate

diversification
Stability Divestment

business
- Satisfaction with status quo - Inadequate profit - Poor strategy High High Low Low Low Low

Diversification Debate

Pros and Cons

Reduces overall risk exposure Expands opportunities for growth Dampens profitability

Diversification and Risk Reduction

ROI A
(A+B)

Why Conglomerates Can Add Value in Emerging Markets

Khanna 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 Failure Capital markets

Product markets Resource markets Risk markets

Form of Diversification Unrelated diversification Vertical integration

Source of Value Addition

Governance economies Coordination economies Related diversification Scope economies

Strategic diversification Option economies

Diversification A Mixed Bag

Positives

Negatives

Managerial economies of scale Higher debt capacity Lower tax burden Larger internal capital

Dissipation of managerial focus Unprofitable investment.

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. 2. 3. 4. 5. If you lack financial sinews to sustain the new project during the learning period, avoid grandiose diversification projects. Realistically examine whether you have the critical skills and resources to succeed in the new line of business. Ensure that the diversification project has a good fit in terms of technology and market with the existing business. 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. Where possible adopt the following sequence: marketing substantial subcontracting full blown manufacturing.

6.
7. 8. 9.

Seek partnership of other firms in areas where you are vulnerable or competitively weak.
If the failure of the new project can threaten the companys existence, float a separate company to handle the new project. Remember that meaningful conglomerate diversification represents the greatest challenge to corporate vision and leadership. 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
Market Share
M a r k e t G r o w t h R a t e High

Low

High Stars

Question Marks

Low

Cash Cows

Dogs

Pattern of Capital Allocation

Part A
Stars Question marks

Cash cows (funds generated)

Dogs on divestment (funds released)

Part B
Stars
1 Cash cows Dogs

Question marks

General Electrics Stoplight Matrix

Business Strength
A t t r a c t i v e n e s s
Strong
H i g h M e d i u m L o w

Average

Weak

I n d u s t r y

Invest

Invest

Hold

Invest

Hold

Divest

Hold

Divest

Divest

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:
Industry Attractiveness Criteria Industry size Industry growth Weight 0.10 0.30 Competitive Position Key Success Factors Market share Technological know how Weight 0.15 0.25

Industry profitability
Capital intensity Technological stability Competitive intensity Cyclicality

0.20
0.05 0.10 0.20 0.05

Product quality
After-sales service Price competitiveness Low operating costs Productivity

0.15
0.20 0.05 0.10 0.10

Assessment of the SBU Factory Automation

Industry Attractiveness
Criteria Industry size Industry growth Industry profitability Capital intensity Technological stability Competitive intensity Cyclicality Weight 0.10 0.30 0.20 0.05 0.10 0.20 0.05 Rating 4 4 3 2 2 3 2 Weighted Score 0.40 1.20 0.60 0.10 0.10 0.60 0.10 3.10 Weight Score 0.60 1.25 0.60 0.60 0.20 0.40 0.50 4.15

Competitive Position Key Success Factors Market share Technological know how Product quality After-sales service Price competitiveness Low operating costs Productivity Weight 0.15 0.25 0.15 0.20 0.05 0.10 0.10 Rating 4 5 4 3 4 4 5

The McKinsey Matrix

Competitive Position
A t t r a c t i v e n e s s
Good High Winner Medium Winner Poor Question Mark

I n d u s t r y

Medium

Winner

Average Business

Loser

Low

Profit Producer

Loser

Loser

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 maximisation, many corporate boards and senior managements commit to other objectives.

Enhancing the Effectiveness of Corporate Portfolio Management

1. Create a team of independent people for portfolio review. 2. Improve the quality of information. 3. 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

Porters Generic Competitive Strategies

Sources of Competitive Advantage: Unique Value as Perceived by Customer Broad (industry-wide) Strategic Scope Narrow (segment only) Lowest Cost

Overall Differentiation

Overall Cost Leadership

Focused Differentiation

Focused Cost Leadership

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

Environmental assessment

Managerial vision, values, and attitudes

Corporate appraisal

Strategic plan

Capital budgeting

Product strategy, market strategy, production strategy, and so on

Generic Strategies and Key Options

Status Quo
Conglomerate Diversification FOCUS COST LEADERSHIP Aggressive

FS

Concentric Diversification Concentration Vertical Integration IS

Diversification
CA Divestment

Conservative

Defensive

Competitive

Concentric Merger

Liquidation

GAMESMANSHIP

DIFFERENTIATION Conglomerate Merger Turnaround ES

Retrenchment

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 analysed 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 subserve the strategy of the firm. Hence, the relationship between strategic planning and capital budgeting must be properly recognised.