Chapter 7 Corporate Strategy and Capital Budgeting Decision

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Chapter 7 Corporate Strategy and Capital Budgeting Decision Powered By Docstoc
					          Chapter 7
Corporate Strategy and Capital
     Budgeting Decision

   Capital Budgeting and Investment
           Analysis by Shapiro
• 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
  Competitive markets and excess
• 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
• 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
• There are inherent cost advantages to being
• 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
• 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
        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
• 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
• 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
                  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
• 2. Develop the highest product/quality
  differentiated position within the industry,
  while maintaining an acceptable delivered
  cost structure
   Corporate strategy and foreign
• 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
• World scale: large volume if firms expand
  overseas. Size necessary in certain industries
  to compete effectively in the global market
• 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
• 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)

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