Topic 11:
• Strategic Considerations in
Capital Investing:
– Capital budgeting decisions and
owner's wealth
Learning Objectives Satisfied:
7. Cash Flow Estimations and Capital
Budgeting Techniques
• Objectives: Understand the following
concepts
Why it is so hard for firms to find profitable
investment opportunities
Purpose:
• Examine the role of strategy in capital
budgeting
• Integrate NPV analysis with asset pricing
theory and option pricing theory
What is NPV and what causes it
to be positive?
• NPV is the difference between the value of
the securities issued by a firm and the cost
of the resources committed
• Positive NPVs come from economic rents
Sources of economic rents
• Becoming a low-cost producer
– increased efficiency
– power over suppliers of inputs
• Gaining monopoly power
–
–
–
–
patent protection
proprietary knowledge
product differentiation
switching costs
Positive NPVs do not arise from things that
investors can do by themselves
• Diversification that merely reduces risk has
no market value
• No value in mergers that merely internalize
risk sharing that could be accomplished
with futures, options, swaps, or other
derivatives
Applying the NPV Rule
• Problem is to predict what the prices of your
company's securities will do when project is
announced
The discounted cash flow
approach:
• Assumes the firm is a portfolio of projects
that are analogous to bonds
• Assumes firm can be managed using the
same basic tools that are used by a manager
of a portfolio of securities
• This approach needs to be modified to
deal with strategic considerations
Strategic Considerations
• What happens when VAP doesn't hold?
– strategic considerations may involve synergy
(projects that work together)
– or anergy (projects that conflict)
• Strategic considerations also include
– growth options
– abandonment options
– pursuit of comparative advantage
Other quantitative approaches
• Capital budgeting applications using option
pricing theory (currently under
development)
– Valuing abandonment options
– Valuing natural resource investments (e.g.,
mines, oil leases, etc.)
– Valuing a project's flexibility
Other quantitative approaches
• Additional hoped-for future developments
in applying OPT
– Valuing growth options
– Valuing contingency plans
• Surrogate portfolios
Qualitative alternatives:
• Looking for economic rents directly instead
of indirectly
• Core Competencies
• Competing on Capabilities
• Product/Market strategies
• Analyzing the competitive environment
Fossil Inc.
Seiko
price
Opportunity
Space
Casio
Timex
quality
Porter’s Generic Product/Market
Strategies
Broad Market
Lower Cost
Differentiation
Cost Leadership
Differentiation
Stuck in
the middle
Focused Market
Cost Focus
Differentiation Focus
Porter’s method for analyzing
competitive environment
New Entrants
Suppliers
Industry Rivals
Customers
Substitutes
Discussion Questions:
• Is there a common ground shared by
stockholders, employees, and the host
community?
• Whose interests do managers serve when
they seek a winning strategy?
• Does a broadly diversified investor with a
slice of the whole market portfolio care
which companies win the strategic battles?
Symptoms of capital inefficiency
•
•
•
•
•
•
•
Blanket Spending
Unintegrated approach
Myopic planning
“Entitled” spending
Missed budget targets
Badly aligned incentives
No post-audit procedure
How to take a strategic approach to
the expansion process
• Strategic planning and project
generation:
– Strategic planning is not masterminding the
future
– One successful approach is multiple-scenario
planning
• basic idea is to keep open as many options as
possible
How to take a strategic approach to
the expansion process
• Analysis and decision: strategic planning goes
beyond preparing for an uncertain future
– It involves the search for excellence
– The process demands that executives ruthlessly
analyze their firm’s strengths and weaknesses
• Executives should ask, “What does this particular
organization do better than anyone else can do it?”
• Projects undertaken by the firm should be aimed at
exploiting its strengths
How to take a strategic approach to
the expansion process
• Executives should also ask, “What
opportunities do we have to start building
future comparative advantage?”
– Projects should be chosen with an eye toward
building such future advantages
How to take a strategic approach to
the expansion process
• Analysis and decision:
– First step: choose incremental decision
approach or mega project approach
– Next: decide whether to rely primarily upon
quantitative or qualitative approach
• Try to do justice to both quantitative and
qualitative considerations
Pitfalls in the analysis phase:
•
•
•
•
Deceptive accuracy of quantitative techniques
Tendency to generate biased inputs
Lack of clarity in defining a good investment
Lack of consideration for competitors'
responses
• Lack of consideration for customers' responses
• Lack of consideration for suppliers' responses
• Distorted view when using WACC
What’s wrong with WACC?
L
SM
Return
• Project A is above
WACC, but below
SML
• Project B is below
WACC, but above
SML
• WACC would
wrongly reject B and
accept A
A
WACC
B
Rf
1
Beta
Project implementation:
• Project implementation is the most timeconsuming and demanding phase of the expansion
process
– but is often considered to be outside the boundaries of
the finance discipline
• Facilitated by tools from management science
(such as critical path analysis or the PERT
technique)
– But these are not generally taught in finance courses
and do not involve the “tools of finance.”
Postaudit: Learn from past
successes and mistakes
• One way to deal with bias is careful attention to
postaudit
• Postaudit program encourages review of all projects
after they have become fully established
– to assess accuracy of projections
– patterns of bias can be corrected
• Also wise to do a postaudit of projects that were
disapproved
– Did competitors succeed?