Financial Theory and Corporate
Strategy
Purpose: Integrate the major concepts of
corporate finance and corporate strategy
Proven ways to increase shareholders’
wealth:
FFind investment opportunities that beat
the market
l Find
better business unit strategies than
anyone expected you would
l winning isn’t enough; you have to beat
the point spread
It’s not winning or losing that
counts, son. What counts is beating
the point spread.
Proven ways to increase shareholders’
wealth:
FStop non-competitive activities
FPay out cash
l (making
promises about future dividends
doesn’t count)
l this leads to gradual liquidation
FBe acquired by another company
FSpin off any divisions that can stand
alone
What is NPV and what causes it to
be positive?
F NPV is the difference between the value of
the securities issued by a firm and the cost
of the resources committed
F Positive NPVs come from economic rents
Sources of economic rents
F Becoming a low-cost producer
l increased efficiency
l power over suppliers of inputs
F Creating or enhancing valuable real options
l such as options for growth, flexibility,
exit, or timing
F Gaining monopoly power or market power
l Through patent protection, proprietary
knowledge, product differentiation, or
switching costs
Porter’s Generic Product/Market
Strategies
Broad Market
Lower Cost
Differentiation
Cost Leadership
Differentiation
Stuck in
the middle
Focused Market
Cost Focus
Differentiation Focus
A Practical Lesson: What causes
NPV to be positive?
FPositive NPV results from improved
resource allocation through
cooperation—or through innovation
l
There would be no positive NPV if many
individuals could accomplish the same actions
on their own
A practical lesson:
F In order to create positive NPV
opportunities, managers must do something
that stockholders cannot do by themselves.
Positive NPVs do not arise from
things that investors can do by
themselves
F Diversification that merely reduces risk has
no market value
F No value in mergers that merely internalize
risk sharing that could be accomplished by
independent companies through hedging
with futures, options, swaps, or other
derivatives
Applying the NPV Rule
F Problem is to predict what the prices of your
company's securities will do when action is
announced
The discounted cash flow approach:
F Quantitative models assume the firm is a
portfolio of projects that are analogous to
bonds
F Assume the firm can be managed using the
same basic tools that are used by a manager
of a portfolio of securities
F This approach needs to be modified to
deal with strategic considerations
Strategic Considerations
F What happens when VAP doesn't hold?
l strategic considerations may involve
synergy (projects that work together)
l or anergy (projects that conflict)
F Strategic considerations also include
l growth options
l abandonment options
l pursuit of comparative advantage
Other quantitative approaches
F Capital budgeting applications using option
pricing theory (currently under
development)
l Valuing abandonment options
l Valuing natural resource investments
(e.g., mines, oil leases, etc.)
l Valuing a project's flexibility
Other quantitative approaches
F Additional hoped-for future developments
in applying OPT
l Valuing growth options
l Valuing contingency plans
F Surrogate portfolios
Qualitative alternatives:
Verifying economic rents directly instead of
indirectly
F Core Competencies
F Competing on Capabilities
F Product/Market strategies
F Analyzing the competitive environment
Another Alternative
F Project financing:
l Managers as developers
l Southport Minerals Case
Impediments in Using NPV
F Market imperfections and market
inefficiencies can foul things up.
F Externalities can also foul things up
l An externality occurs whenever someone
benefits from a venture without investing
any resources in it, or incurs a cost from a
venture without participating in the
benefits.
How Efficient is the Capital
Market?
F Purpose: This discussion is intended to
upgrade your understanding of the theory
of capital market efficiency.
Three aspects of capital market
efficiency
F allocational efficiency
F operational efficiency
F pricing efficiency (or “fair-game” efficiency)
Allocational Efficiency
F We say that the market is allocationally
efficient if it facilitates the achievement of a
“Pareto optimal” allocation of resources.
Achieving a Pareto Optimal
Allocation
F A Pareto optimal allocation has been
achieved if there is no alternative
reallocation which would make at least one
person happier without at the same time
making someone else unhappier.
l Another way of saying this is that at a
Pareto optimum, no more free trading
will be desired.
Achieving a Pareto Optimal
Allocation
F Of course, in a dynamic world, such a
stopping point will probably never be
reached
l We don’t want any impediments in the
way, however.
F The Pareto standard is often criticized for
failing to address inequities in the initial
endowment of resources.
Necessary Conditions for
Allocational Efficiency
F All relevant, available information must be
considered in the process of pricing
securities.
l Therefore, pricing efficiency is necessary
for the capital market to be allocationally
efficient, although it alone is not enough.
Necessary Conditions for
Allocational Efficiency
F Transactions services must be competitively
priced
l Fewest possible resources are consumed
in “making the market.”
l Operational efficiency is also a necessary,
but not sufficient, condition for
allocational efficiency.
Two More Necessary Conditions for
Allocational Efficiency
F There must be no negative externalities.
F The capital market must be “complete”
l there is a security available to meet the
special needs of every potential investor.
Signs of Pricing Efficiency
F There are no persistent arbitrage
opportunities. That is, purchases and sales
of securities are zero-NPV transactions.
F Security prices are random and
unpredictable.
Tests of Pricing Efficiency
F The weakly efficient capital market
hypothesis
F The semi-strong efficient capital market
hypothesis
F The strongly efficient capital market
hypothesis
Weak Efficiency
F Information Mass
includes price and
volume data only
F Status: Security prices
fully reflect transaction
data
Semi-Strong Efficiency
F Information Mass
includes:
l
l
Price data
All other publicly
available information
F Status: Security prices
fully reflect all
publicly available
information
l
Prices adjust to arrival
of new information
within a few minutes
Strong Efficiency
F Information
Mass includes all
information
l
l
l
Price Data
Other Publicly
Available Info
Privileged Info
F Status: Markets
are not strongly
efficient
l
Traders with
privileged
information can
beat the market
Six Lessons of Market Efficiency
F The market has no memory.
F Trust market prices. Randomness goes
hand-in-hand with rationality.
F There are no financial illusions.
F There is usually a do-it-yourself alternative
to corporate financial decisions.
F If you’ve seen one stock, you’ve seen them
all.
F Market efficiency does not imply perfect
forecasting ability.
Statement for Discussion:
F We may indeed hope, but all we can
rationally expect in an efficient market is
that we shall obtain a return that is just
sufficient to compensate for the time value
of money and for the risks we bear.
How Strategic Analysis Takes a
Portfolio Perspective
Porter’s method for analyzing
competitive environment
New Entrants
Suppliers
Industry Rivals
Substitutes
Customers
The generic value chain for a firm:
Support
Activities
Firm Infrastructure
Procurement
Technology Development
Human Resources Development
Inbound
Logistics
Operations
Outbound
Logistics
Marketing &
Sales
Service
Primary Activities
The physical value chain from a
global perspective:
Support Activities:
•Technology Development
•Human Resources
Development
Service
Distribution&
Marketing
Fabrication
Refining
Basic Extraction
Physical
Realm
Value Added at
Each Step
Virtual Value Chain & Information Operations
GATHER AND APPLY IN THE PHYSICAL REALM
STORE AND TRANSFORM IN THE INFORMATION REALM
APPLY
PRESENT
DISTRIBUTE
SYNTHESIZE
SELECT
ORGANIZE
Infosphere
GATHER
The Finance Perspective on
Portfolio Theory
Why take a portfolio viewpoint?
F Diversification reduces risk
l Additional securities increase reward,
reduce risk
l Small holdings are inefficient
F Individual securities are fungible
Highlights of Portfolio Theory
F Fundamental
Assumption
l Two dimensions:
Risk & Reward
F Law of One Price
Reward
Market Line
Risk
Measuring risk and reward for
diversified portfolios
F Why mean and standard deviation of return
were chosen
l Mean
= best estimate of future
performance
l Standard
deviation defines the
confidence interval around this estimate
F Together
l They express the probability of an event
Implication:
F A simple investment rule is implied by the linear relationship
between mean return and standard deviation:
l
All portfolios on the CML have the same probability of
earning a higher return than Treasury Bills
E(R)
CML
9%
7%
5%
s
2%
4%
Under what circumstances would
mean and standard deviation be
insufficient?
F Skewed distributions
l i.e., options
F “Fat-tailed”
distributions
l i.e., day-to-day
returns for
individual stocks
Tobin's capital market theory
F Capital market line
F Optimal investment
strategy
l second separation
theorem
F What it really means
about finding good
investments
Expected
Return
CML
P*
efficient
frontier
standard
deviation
Diversification reduces risk
F A relatively small
portfolio (12 to 15
securities) does a very
good job.
F Portfolio performance
reverts to mean
This leads to the Value Additivity
Principle:
F Diversification has no market value
l If it did, there would be arbitrage opportunities
l Conclusion: the value of the whole just equals the sum of
the values of the parts
F This realization serves as the springboard into Asset Pricing
Theory
l Which computes value based on an asset’s contribution to
the risk and return of a portfolio
F Does completing the market add value?
l Answer: Yes
l Conclusion: value of whole may be less than sum of parts
Partitioning total risk into systematic and
unsystematic elements: The Intuition
F Assignment: design a video game to mimic stock market
F Step 1: Random move applies equally to all stocks
F Step 2: Assign response coefficient to each stock
l Average of all coefficients is one
F Step 3: Add unique random move for each stock
l Average of all these is zero
F Question: What happens if a player diversifies across all the
stocks in this game?
Analyzing the firm as a portfolio of
projects:
F Synergy: The parts work together, so the
whole is worth more than the sum of the
parts
F Anergy: The parts work against each other,
so the whole is worth less than the sum of
the parts
l If anergy present, firm should break apart
VAP doesn’t always hold in these cases
Why Form Companies?
F Without synergy, the existence of the firm provides
no advantage for the investors
l They could diversify on their own, without the
overhead of central management.
F “Strategy applies at the business unit level [not the
firm level]”--M. Porter
l Corporate strategies, if valid, focus upon interbusiness synergies
How to Take a Strategic
Approach to the Processes of
Expansion and Contraction
How to take a strategic approach to
the expansion process
F Strategic planning and project generation:
l Strategic planning is not masterminding
the future
l One successful approach is multiplescenario planning
—basic idea is to keep open as many options as
possible
How to take a strategic approach to
the expansion process
F Analysis and decision: strategic planning
goes beyond preparing for an uncertain
future
l It involves the search for excellence
l 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?”
—Projects undertaken by the firm should be aimed at
exploiting its strengths
How to take a strategic approach to
the expansion process
F Executives should also ask, “What
opportunities do we have to start building
future comparative advantage?”
l Projects should be chosen with an eye
toward building such future advantages
How to take a strategic approach to
the expansion process
F Analysis and decision:
l First step: choose incremental decision
approach or mega project approach
l Next: decide whether to rely primarily
upon quantitative or qualitative approach
F Try to do justice to both quantitative and
qualitative considerations
Pitfalls in the analysis phase:
F
F
F
F
F
F
F
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
F Project A is above
WACC, but below
SML
F Project B is below
WACC, but above SML
F WACC would wrongly
reject B and accept A
Return
What’s wrong with WACC?
SM
B
L
A
WACC
Rf
Beta
Project implementation:
F Project implementation is the most timeconsuming and demanding phase of the
expansion process
l
but is often considered to be outside the
boundaries of the finance discipline
F Facilitated by tools from management
science (such as critical path analysis or the PERT
technique)
l But these are not generally taught in finance
courses and do not involve the “tools of
finance.”
Postaudit: Learn from past successes
and mistakes
F One way to deal with bias is careful
attention to postaudit
F Postaudit program encourages review of all
projects after they have become fully
established
l
l
to assess accuracy of projections
patterns of bias can be corrected
F Also wise to do a postaudit of projects that
were disapproved
l
Did competitors succeed?
How to take a strategic approach to
the contraction process
F Stop doing things you don’t do well or cheaply.
F Outsource activities that others can do better
or cheaper.
F Eliminate sources of anergy (caused by parts of
the organization that work against each other)
How to take a strategic approach to
the contraction process
F Ownership isn’t always the best policy: sell
assets you don’t have to own in order to remain
competitive
l airlines that lease planes
l railroads that lease rolling stock
l hotel companies that have sold their hotels
l companies that lease headquarters facilities
or other real estate
Discussion Questions:
F Is there a common ground shared by
stockholders, employees, and the host
community?
F Whose interests do managers serve when
they seek a winning strategy?
F Does a broadly diversified investor with a
slice of the whole market portfolio care
which companies win the strategic battles?