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Chapter 2

Strategy and Capital Allocation



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

Strengths and weaknesses

Determine core capabilities
Find the fit between
core capabilities and
external opportunities
Firms strategies
Diversification
Grand
Strategy
Growth Contraction Stability
Concentration Vertical
integration
Liquidation Divestiture
The 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
A
B
(A+B)
ROI
Diversification Debate
Pros and Cons
Reduces overall risk exposure
Expands opportunities for growth
Dampens profitability
Diversification and Risk Reduction
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
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
High
Low
Low
High
M
a
r
k
e
t

G
r
o
w
t
h

R
a
t
e
Stars
Question
Marks
Cash
Cows


Dogs


Market Share
Pattern of Capital Allocation

Stars Question marks


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

Stars Question marks
1

Cash cows Dogs
Part A
Part B
General Electrics Stoplight Matrix
Business Strength
H
i
g
h

M
e
d
i
u
m

L
o
w

A
t
t
r
a
c
t
i
v
e
n
e
s
s

I
n
d
u
s
t
r
y

Invest
Invest
Hold
Divest Hold
Invest
Hold
Divest
Divest
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:

I ndustry Attractiveness

Competitive Position

Criteria

Weight

Key Success Factors

Weight

Industry size

0.10

Market share

0.15

Industry growth

0.30

Technological know how

0.25

Industry profitability

0.20

Product quality

0.15

Capital intensity

0.05

After-sales service

0.20

Technological stability

0.10

Price competitiveness

0.05

Competitive intensity

0.20

Low operating costs

0.10

Cyclicality

0.05

Productivity

0.10

Assessment of the SBU Factory Automation
I ndustry Attractiveness


Criteria

Weight

Rating

Weighted Score

Industry size

0.10

4

0.40

Industry growth

0.30

4

1.20

Industry profitability

0.20

3

0.60

Capital intensity

0.05

2

0.10

Technological stability

0.10

2

0.10

Competitive intensity

0.20

3

0.60

Cyclicality

0.05

2







Competitive Position


Key Success Factors

Weight

Rating

Weight Score

Market share

0.15

4

0.60

Technological know how

0.25

5

1.25

Product quality

0.15

4

0.60
After-sales service

0.20

3

0.60

Price competitiveness

0.05

4

0.20

Low operating costs

0.10

4

0.40

Productivity

0.10

5







0.10

3.10

0.50

4.15



A
t
t
r
a
c
t
i
v
e
n
e
s
s


Good

Medium

Poor

High

Winner

Winner

Question Mark

Medium

Winner

Average Business

Loser

Low

Profit Producer

Loser

Loser

I
n
d
u
s
t
r
y

The McKinsey Matrix
Competitive Position
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:

I ndustry 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
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

Sources of Competitive Advantage:

Unique Value as Lowest Cost
Perceived by
Customer

Broad
(industry-wide)
Strategic Scope

Narrow
(segment only)

Overall Overall Cost
Differentiation Leadership


Focused Focused Cost
Differentiation Leadership
Porters Generic Competitive Strategies
Environmental
assessment
Managerial vision,
values, and attitudes
Corporate
appraisal
Strategic plan
Capital
budgeting
Product strategy,
market strategy,
production strategy,
and so on
Strategic Planning and Capital Budgeting
COST
LEADERSHIP
Aggressive
FOCUS

Conservative
Defensive


GAMESMAN-
SHIP
Competitive


DIFFEREN-
TIATION
FS
ES
CA IS
Concentric Diversification
Concentration
Vertical
Integration
Concentric
Merger
Conglomerate Merger
Turnaround
Status Quo
Conglomerate
Diversification
Diversification
Divestment
Liquidation
Retrenchment
Generic 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 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.