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									Chapter 14 - Strategic Issues in Making Investment Decisions



                                            CHAPTER 14
                 Strategic Issues in Making Investment Decisions
Chapter Outline

A.      Cost Management Challenges — Chapter 14 presents four cost management challenges.

        1.       What are the differences between expansion, replacement, and strategic move
                 investment?

        2.       What do net present value, real option value analyses imply for the success in long-term
                 decisions?

        3.       What are ethical implications in capital budgeting decisions?

B.      Learning Objectives

        1.       Describe the strategic importance of capital investments.

        2.       Identify external and internal information for strategic investments.

        3.       Learn to use forecasts of quantitative and qualitative effects of strategic investments in
                 net present value analysis.

        4.       Model the impact of competitor’s actions.

        5.       Know when and how to apply real option analysis to evaluate strategic investments. .

        6.       Identify and apply ethical issues in strategic investment decisions.

C.      Strategic planning is the process of deciding on an organization’s major programs and the
        approximate resources devoted to them. Major programs consist not only of products and
        product lines but also major research and development projects. Strategic plans are based on an
        organization’s overall objectives for its existence. As such, strategic planning is done for projects
        that encompass long periods of time. Strategic planning must also encompass consideration of
        market forces and changes in one’s industry. Ongoing changes in an industry need to be
        incorporated into changes in an organization’s strategic planning.

        Capital investment decisions are a product of strategic plans. Capital investments require
        substantial monetary commitments that have the intended result of generating profits over periods
        that are typically much longer than one year. Financial decisions that have an impact or duration
        of one year or less are considered to be short-term decisions.

        Financial models are representations of reality in the business world. A model allows one to see
        how something is supposed to work. A financial model allows an organization to test the
        interaction of economic variables in a variety of settings.




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C.      Identification of good investments can be the result of natural transitions from existing operations
        to operations that incorporate changes that are clearly warranted. A case in point is the decision
        by automobile manufacturers to shift from human labor to robotics in their assembly lines.
        Technology changes that improved production activities were clearly advantageous over the
        existing production methods. Other investment decisions are not so obvious. Furthermore,
        organizations that fail to respond in time to the need to shift their strategic plan and make the
        correct capital investment decisions run the risk of going out of business.

        There are three general types of long-term capital investments. These three types are presented in
        Chapter 14. They are (1) replacement and minor improvements, (2) expansion, and (3) strategic
        moves.

        1.       Replacements and minor improvements are just replacements of existing long-lived
                 assets that wear out or become obsolete. This is not a major strategic decision. It usually
                 requires that managers consider different alternatives for replacing the asset. Cost,
                 efficiency, and time factors are all considered.

        2.       Expansion decisions occur as an organization works toward achieving growth. This type
                 of capital investment may arise out of necessity because demand for a company’s
                 products has exceeded its ability to produce or provide the product. Expansion activities
                 to increase capacity provide an obvious incentive to grow and expand.

        3.       Expansion may also result from an organization’s desire to move into new markets.
                 Expansion to other countries, into other geographical regions in a region, adding new
                 product lines, or increasing the number of locations in the current market all are examples
                 of expansion activities. Expansion activities that lead to operations in new locations or
                 new production activities are considered to be strategic expansion activities or strategic
                 moves. Strategic expansion activities are more risky than expansion to increase capacity.
                 There are many unknown factors to address when moving to uncharted waters. Top
                 management may rely on market studies, outside consultants, experts in the industry an
                 organization wants to expand into, or people with knowledge of the history and cultural
                 norms of a country being considered for market entry. Technical expertise is also sought
                 in order to identify the actual procedures for accomplishing the proposed strategic move.

                 Strategic moves may result from responses to market conditions (like Barnes and Noble’s
                 recognition that it had to offer Online services to compete with Amazon.com); it might
                 result from product innovations (like Microsoft’s combination of its operating system
                 with an entire package of software tools); or it may result from proactive organizational
                 planning activities. Some organizations employ strategic planners whose sole purpose is
                 to develop strategic moves.

D.      Due diligence is a legal term. It is the due process or appropriate steps in an investigation. During
        due diligence investigations, people look for potential problems with a prospective investment.
        The main objective of due diligence is to ascertain that there will be no unpleasant surprises that
        occur after the investment has been made. Due diligence can be split into four areas. They are (1)
        legal, (2) environmental, (3) public relations, and (4) employee relations.




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        1.       Before making a major investment, organizations must investigate all of the legal
                 repercussions of the planned investment. This is especially important when companies
                 are considering expanding to other countries. There are tax, import, and export laws that
                 can affect the profitability of a strategic move. Some countries restrict the amount of
                 foreign labor or have laws regarding minimum wages, amount of production materials
                 and other resources that can be brought in from outside of the country, and even how
                 much profit can be taken out of the country. Although bribery is illegal in the US and
                 many other countries, it is a cultural norm in some locales. Managers must decide how to
                 deal with all of these legal issues.

        2.       Due diligence may be related to environmental issues. Companies must be aware, to the
                 extent possible, of possible environmental hazards they might later be held responsible
                 for. They must also be aware of environmental laws in the location where they are
                 planning to move. Investigation into the history of plant sites should include searches for
                 information regarding environmental hazards that exist there.

        3.       Public relations issues arise when a company expands into new areas that have a
                 detrimental effect on their public image. For instance, Nike became embroiled in
                 controversy when it was learned that some of its overseas production facilities used child
                 labor and violated child labor laws.

        4.       Employee relations must also be considered when a strategic move is being considered.
                 Some strategic moves result in the transfer of employees far from their homes. Other
                 moves may result in the elimination of jobs. Still others place existing employees in the
                 role of managers of new employees from other cultures, and they may be inexperienced
                 in dealing with different languages or cultural norms.

E.      Financial information is a critical piece of the strategic planning puzzle. Cost managers are
        involved in providing financial information. A key to good financial planning for capital
        investments is sound estimates of cash flow alternatives. Managers must identify what the cash
        outlays will be, estimate cash flows from the investment, and project cash flow needs for the end
        of the investment project (if the project does not have an indefinite life). The timing of cash flows
        is important because of the time value of money. A dollar today is worth more than a dollar
        obtained next year, because the dollar currently held could be invested for a year. The entire issue
        of the timing of cash flows is addressed in the appendix to this chapter and in basic texts for
        finance courses.

        There are three sources of financial information that the cost manager can access to help their
        fellow managers to evaluate a potential investment. They are (1) financial records, (2) interviews
        with operating and marketing personnel, and (3) industry data and competitor analysis.

        1.       Financial records are the most beneficial when an investment decision is similar to
                 decisions made in the past. Historical financial information is a good starting point. From
                 this information, cost managers can modify the numbers to fit the pending investment.
                 Known differences can be incorporated into the analysis. Historical financial information
                 can be used for replacement decisions or expansions of existing operations to meet higher
                 demand. Financial information for strategic moves is less helpful, because it may not be
                 applicable to the planned strategic move. If the move is into completely different
                 products or different countries, there are many factors that will not be present in historical
                 financial information.


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        2.       A second source of good information is to interview operating and marketing personnel.
                 Cost managers can obtain first-hand information about how production activities are
                 accomplished. Operations managers can provide details, step-by-step, of the cost-causing
                 activities that they supervise. For replacement or expansion decisions, operating
                 managers often can suggest the best solutions to these investment problems.

                 Marketing people are useful sources of information about the competitive environment.
                 People with marketing expertise can advise on the potential for the success or failure of
                 entry into new markets, addition of new products, or changes in the way existing products
                 are offered.

        3.       A third useful source of information is industry data and competitor analysis. Regardless
                 of the industry an organization is in, there is normally a wealth of published information
                 that can help in making the investment decision. Company and industry Web sites,
                 corporate financial statements, and other publicly available information can be used to
                 evaluate a project’s potential. Since cost managers do not usually have this kind of
                 expertise or first-hand knowledge of it, it is wise to hire outside consultants to aid them in
                 making the correct decision. For a strategic move, the only source of information may be
                 that obtained from industry data and competitor analyses. Especially useful, for strategic
                 moves that are responses to competitors’ strategies, is identifying what worked for one’s
                 competitors.

F.      Although a for-profit organization certainly would want to go forward with a profitable business
        venture, it must also consider some non-financial factors that could affect the overall appeal of an
        investment decision. These are discussed below.

        1.       There are non-quantifiable effects on employee morale, the community, and the
                 environment that should be considered. Capital investment decisions can affect the
                 security of employment, may cause employees to be relocated, or may cause other related
                 stresses that make working for the organization undesirable. On the other hand, some
                 capital investment decisions open up opportunities for employees that might not
                 otherwise exist.

                 An organization’s shift in strategy may have a positive or a negative effect on a
                 community. A plan to shift operations overseas — to countries where labor costs are
                 lower — could be devastating to the community where the jobs are lost but could be an
                 economic windfall to the community where the jobs are moved.

                 Environmental impact of a strategy change may also be positive or negative. Aside from
                 the costs of complying with environmental laws, organizations must be good corporate
                 citizens, who do not pollute, who do not locate undesirable facilities where members of
                 the community do not want them, and who make visible contributions for the social good
                 of the community.

        2.       Ethical issues come into play for a variety of reasons. First, what may be legal may not
                 always be ethical based on a company’s own code of ethics. For instance, child labor
                 laws may be more lenient than some companies are willing to tolerate in some countries.
                 Some countries allow bribery of government officials to occur, but companies may have
                 strict policies against that.



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                 At another level, managers may violate the ethical codes in their own organization to
                 accomplish the objectives of the organization. It becomes difficult to enforce company
                 ethical codes in a global organization, particularly when employees may have different
                 cultural or ethical philosophies than those adhered to by the company.

        3.       Another issue to consider, even though it may be hard to quantify, is the benefit of
                 experiences gained from the investment opportunity being embarked upon. Most strategic
                 moves involve some sense of adventure because an organization and its employees are
                 exploring opportunities that are new or foreign to them. Strategic moves provide
                 opportunities for managers to learn about new ways of conducting their business. They
                 may learn about new technologies, processes, new markets, and new kinds of markets.

                 For instance, Ford Motor Company initially rejected a capital project that would have
                 revolutionized production processes. Based on the discounted cash flow analysis, the
                 project should have been rejected. The CEO of Ford argued that the non-quantifiable
                 benefits outweighed the financial deficit and authorized the project. He believed,
                 correctly, that Ford would learn how to apply computerized manufacturing processes by
                 acquiring the computerized equipment. This turned out to be true.

G.      Managers involved in making strategic decisions are often confronted with projects that are
        related to technology. In addition to the complexity of technology changes, which are not likely
        to be well understood by cost managers, there are other barriers to making right choices when
        technological changes are involved.

        1.       Production and engineering people see the benefits of technology change. Finance and
                 accounting people may only focus on the costs of technology.

        2.       In performing discounted cash flow analysis, managers make the discount rate higher
                 when there is uncertainty. The discount rate should be the cost of capital, adjusted for
                 risk. Cost managers may overstate the risk, causing a high-tech project to show a negative
                 net present value (meaning the project should be rejected).

        3.       The length of time that benefits can be obtained from a high-tech project may also be too
                 short. If the cash flow analysis doesn’t include enough years of benefit, the project will
                 be rejected.

        4.       Discounted cash flow analysis should not be the only tool used to assess the viability of a
                 high-tech project. The non-quantifiable benefits of accepting technology change may
                 include more flexibility in the production process, shorter cycle times and reduced lead
                 times, and reduction of non-value-added activities and costs.

        5.       Companies that do not make the technology investments when their competitors do may
                 forego opportunities to remain competitive on product quality, production efficiency, or
                 other dimensions




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I.   Sensitivity analysis in the strategic planning arena is a very important step to take. Since there are so
     many uncertainties associated with any investment decision that lasts for long periods of time, it is a
     good idea to consider many possible outcomes. These different outcomes are the result of changing
     assumptions about different pieces of the strategic plan. Some assumptions that could be reconsidered
     are the amount of initial cash outlay (higher or lower); timing of cash flows over the life of the project
     (faster or slower, more variable than expected, longer or shorter); cost of disposing of assets at the
     end of the project (more costly or less costly). The scenarios should range from a worst-case scenario
     to a best-case scenario, with two or more scenarios in between. Usually, the investment as initially
     proposed falls within these two extremes. Then managers can make the decision knowing what they
     think is the worst possible outcome. At a minimum, four scenarios should be looked at, ranging from
     disaster to disappointing to expected to optimistic.
     In addition to sensitivity analysis, the chapter introduces the concept of ―real option value – ROV‖.
     The impact of external factors, particularly potential competition in project evaluation must be
     assessed and scenarios for the costs and benefits of continuing with the project or abandoning it at a
     certain point in the future must be carefully assessed.

J.       Depending on the magnitude of a capital investment, the final approval may occur at lower levels
         of management (for instance, for equipment replacements or repairs) to the board of directors (for
         strategic moves).

         1.      There may be biases in the process. Everyone involved in a decision to make a capital
                 investment is a stakeholder of sorts. Some may want the project to proceed because it was
                 their idea. Those who propose an investment project may have access to the most and
                 best information related to it. However, the decision-makers should try to eliminate
                 whatever bias may be in the information provided. Others may be biases against an idea.
                 Managers who are used to doing things a certain way may believe in the old adage, ―if it
                 ain’t broke, don’t fix it.‖ They may try to undermine a sound analysis that a project is
                 worthy of pursuit simply because they are not willing to change.

K.       Even though the analysis of the viability of a capital project can be very complex, and time-
         consuming, implementing an approved project is even more complex. Both time and cost
         considerations weigh heavily in the implementation process. Although not as complex for
         replacements and improvements, project implementation can be incredibly complicated for
         strategic moves. Managers may have little or no guidance from the past to develop schedules and
         budgets for cash outlays for the investment. Companies may experience cost overruns and project
         delays that are more than double their worst-case scenario. Other companies discover well into
         the implementation that the project was a mistake and then have to admit that the huge sums
         spent so far are sunk costs. Further spending will not make the project successful.

         Capital projects in overseas markets may experience cost overruns or delays because of
         inexperience in dealing with workers, because of inflationary trends that are much different from
         the home country’s, because of political intervention, or because of poor planning. Some
         political risks may be hard to assess and the added uncertainty will make any educated case less
         than valid.




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L.      During the project’s implementation phase and after a project is completed, managers perform
        audits of the project. An audit of the decision and the implementation process reveal how well the
        investment performed compared to expectations. The capital investment process includes a lot of
        estimates, forecasts, and uncertainties. It is unlikely that a project will turn out just as planned.
        Audits performed on an interim basis can reveal problems and provide information to improve
        future activities on the project. Audits on the project can also provide feedback for future
        projects.

        1.       Audits help management to identify what estimates were wrong so planners can
                 incorporate that knowledge in future estimates to avoid making similar mistakes.

        2.       Audits can be used to evaluate the performance of planners who make good capital
                 budgeting decisions.

        3.       Audits prevent planners from inflating estimated benefits of the project to get it approved.

        4.       Audits make planners accountable and, in that sense, add some degree of discipline to
                 what can, at times, be a subjective judgmental process.

M.      There are three ethical issues in capital investment decisions that may occur. They are (1)
        misstatement of information used to make the investment decision, (2) misstatement of the
        results, and (3) investing in unethical projects.

        1.       Misstatement of information used to make the investment decision will be most likely to
                 come from proponents of the project. Because they believe in a project, those who
                 propose it may be less than objective in their presentation of the information needed to
                 make the decision. Unfortunately, omission of crucial information, or manipulating the
                 information to make the project more acceptable, may not become apparent until the
                 company has invested millions of dollars in it.

        2.       Misstating results is most likely to occur when managers become so committed to it that
                 they are willing to lie about its success. They may have the most personal of interests in
                 the project being continued (they may lose their job if it is ended). Misstatement of
                 results leads to even more of the company’s resources being spent on what could be a
                 losing venture. Although audit can sometimes uncover these misstatements, that is not
                 always the case.

        3.       Investing in unethical projects may occur because of the high returns that could result.
                 This is a high-risk management strategy that can permanently damage an organization’s
                 reputation.

N. Capital investment decisions are made in non-profit and government organizations. The purpose of
   analysis for these organizations is not to see whether profits can be made from an investment. Instead,
   analyses of capital investment opportunities are usually performed because capital is limited. Efficient
   allocation of the resources available is necessary, and capital investment analysis is used to make sure
   that happens.




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