Chapter 7
Corporate Strategy and Capital
Budgeting Decision
Capital Budgeting and Investment
Analysis by Shapiro
Introduction
• Economic rents: are excess returns that lead
to positive NPVs and are the result of
monopolistic control over product or factor
supplies (a real market imperfection)
• An understanding of the strategies followed
by successful firms in defending and exploiting
barriers to entry created by product and
factor market imperfections is crucial to any
systematic evaluation of investment
opportunities
Competitive markets and excess
returns
• A perfectly competitive industry is one
characterized by costless entry and exit,
undifferentiated products and increasing
marginal costs or production
• Any excess returns quickly attracts new
entrants to the market
• Only firms that can bring to bear on new
projects competitive advantages that are
difficult to replicate have any assurance of
earning excess returns in the long run
Competitive markets and excess
returns cont.
• By creating such competitive advantages, a
firm can impose barriers to entry by potential
competitors, resulting in less than perfect
competitive market and the possibility of
positive NPV projects
Barriers to entry and positive NPV
projects
• If these barriers did not exist, new
competitors would enter the market and drive
down the rate of return
• Successful investments are investments that
create, preserve, enhance and capitalize on
competitive advantages which serve as
barriers to entry
Economies of scale
• It exist whenever a given increase in the scale
of production, marketing or distribution
results in a less than proportional increase in
cost
• There are inherent cost advantages to being
large
• High capital requirements go hand in hand
with economies of scale. They serve as
barriers to entry; the more capital required,
the higher the barrier of entry
Economies of scope
• It exist whenever the same investment can
support multiple profitable activities less
expensively in combination than separately
• The existence of economies of scope means
that some efficiencies are wrought by variety
not volume
• Manufacturing systems allows the same
equipment to produce a variety of products
more cheaply in combination than separately
Lesson 1
• Investments that are structured to exploit fully
economies of scale or scope are more likely to
be successful than those that do not.
Cost advantages
• Companies take advantage of the learning
curve to reduce costs and drive out actual and
potential competitors
• We improve with practice
• The cost decline creates a barrier to entry
• Proprietary technology protected by legally
enforceable patents provides another cost
advantage to established companies
Cost advantages cont.
• Monopoly control of low cost raw materials is
another cost advantage open to entrenched
firms
• Favorable locations are important to fast food
restaurants and supermarkets
Lesson 2
• Investments aimed at achieving the lowest
delivered cost position in the industry,
coupled with a pricing policy to expand
market share and more likely to succeed
especially if the cost reductions are
proprietary
Product differentiation
• It can stem from investments in advertising,
R&D or development of service and quality
oriented organization
• The aim is not to be a low cost producer but
to be the low cost provider
• Brand name capital
• A company’s reputation for quality and
integrity permits it to charge a premium price
for a quality product or service
Product differentiation cont.
• Reputation is built up through time by
performance giving customers more than they
expect or through expensive advertising that
creates a quality image in the minds of
customers
• Pharmaceutical companies earn high returns
by developing unique products protected from
competition by patents, trademarks and brand
names
Product differentiation cont.
• Development of technologically innovative
products
• Service is the key to extraordinary profitability
to many firms
• Selling solutions to their customers problems
Lesson 3
• Investments designed to create a position at
the high end of anything, including the high
end of the low end, differentiated by a quality
or service edge, will generally be profitable
Access to distribution channels
• Gaining distribution and shelf space for their
products is a major hurdle for newcomers to
an industry
• Well developed, better yet unique,
distribution channels are a major source of
competitive advantage
Lesson 4
• Investments devoted to gaining better product
distribution often lead to higher profitability
Lesson 5
• Investments in projects protected from
competition by government regulation can
lead to extraordinary profitability. However,
what the government gives, the government
can take away.
Lesson 6
• A company’s ability to exploit fully an
investment in one area may require
supporting investments in other areas. The
corollary is that companies should make the
business strategy, rather than the individual
projects designed to further that strategy, the
focal point of investment analysis
Designing an investment strategy
• The companies that create value are those
that develop business strategies geared
toward achieving one or both of the following
competitive positions within their respective
industries and then tailoring their investments
to attain these positions:
• 1. Become the lowest total delivered cost
producer in the industry while maintaining an
acceptable service/quality combination
relative to competitors
Designing an investment strategy
cont.
• 2. Develop the highest product/quality
differentiated position within the industry,
while maintaining an acceptable delivered
cost structure
Corporate strategy and foreign
investment
• Overseas expansion and survival
• Economies of scale
– Firms in industries characterized by high fixed
costs relative to variable costs must engage in
volume selling just to breakeven
– A Firm that follow a domestic only strategy may
be unable to price competitively in the home
market because it can no longer take full
advantage of economies of scale and scope in
R&D, production, brand awareness, and
distribution
• World scale: large volume if firms expand
overseas. Size necessary in certain industries
to compete effectively in the global market
place
• Knowledge seeking
– Gaining information and experience that is
expected to prove useful elsewhere
– In industries characterized by rapid product
innovation and technical break thoughts by
foreign competitors, it is imperative to constantly
track overseas developments
Designing a global expansion
strategy
• 1. Understand and then capitalize on those
factors that have led to success in the past.
Sources of their domestic advantage must be
transferable abroad
• 2. A systematic evaluation of individual entry
strategies in foreign markets, a comparison of
the alternatives and the selection of optimal
mode of entry
Designing a global expansion
strategy cont.
• 3. A continual audit of the effectiveness of the
current entry modes
• 4. Top management must be committed to
becoming or staying a multinational
corporation (MNC)