Corporate Strategy and the Capital Investment Decision

ByMahmood Osman Imam

Department of Finance University of Dhaka

Strategic Considerations

Selecting value creating capital projects is no different from picking under-valued shares on basis of

fundamental analysis on the stock market.

The existense of economic rents —excess returns that lead to positive net present values — is the result of monopolistics control over product or factor supplies (i.e. ‘real market imperfections’).

These imperfections generally are in the form of entry

barriers which discourage new entrants to the market.

Strategic Considerations

Creating and then taking advantage of imperfections in product and factor markets is the essence of corporate

strategy.

Three logical strategies by Porter(1985):

.To be the lowest cost producer. .To focus on a niche or segment within the

market. To differentiate the product range so that it does

not compete directly with lower-cost products.

Barriers to entry and positive net present value projects

Successful investments (those with positive NPVs) are therefore investments that help create, preserve or enhance competitive advantages that serve as barriers

to entry. Five major sources of barriers to entry: Economies of Scale Economic of scale exist whenever a given increase in the

scale of production, marketing, or distribution results in a less-than-proportionate increase in cost.

Inherent cost advantage in being large. Higher capital requirements go hand-in-hand with economies

of scale.

Barriers to entry and positive net present value projects

Economies of Scale

LESSON # 1: Investments that are structured to fully exploit enonomies of scale are more likely to be successful than those that are not.

Product Differentiation Some companies, such as Coca-Cola and Proctor and

Gamble, take advantage of enormous advertising expenditures and highly-developed marketing skills to differentiate their products and keep out potential competitors wary of the high marketing costs and risks of new product

introduction.

Barriers to entry and positive net present value projects

Product Differentiation

LESSON # 2: 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.

Cost Disadvantages With greater production experience, costs can be

expected to decrease because of more efficient use of labor and capital, improved plant layout and production methods, product redesign and standardization, and the

substitution of less expensive materials and practices.

Barriers to entry and positive net present value projects

Cost Disadvantages Proprietary technology, protected by legally- enforceable

patents, provides another cost advantage to established

companies. Monopoly control of low-cost materials LESSON # 3: Investments aimed at achieving

the lowest delivered cost position in the industry, coupled with a pricing policy to expand market share, are likely to succeed, especially if the cost reductions are proprietary.

Barriers to entry and positive net present value projects

Access to Distribution Channels Gaining distribution and shelf space for their products is a

major hurdle that newcomers to an industry must overcome.

LESSON # 4: Investments devoted to gaining better product distribution often lead to higher profitability.

Government Policy Government policies that raise partial or absolute barriers

to entry include import restriction, environmental controls,

and licensing requirements.

Barriers to entry and positive net present value projects

Government Policy 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.

Capital projects should not simply be viewed in isolation, but within the context of the business, its goals and strategic direction--- termed strategic portfolio analysis.

McKinsey —General Electric

portfolio matrix

High Medium Low

IMPROVE & DEFEND

(Selective investment)

INVEST & GROW

INVEST &GROWH

igh

INVEST &GROW

IMPROVE & DEFEND

(Selective investment)

HARVEST OR DIVESTM

ediu

m

IMPROVE & DEFEND

(Selective investment)

Low

HARVEST OR DIVEST

HARVEST OR DIVEST

Business Strength

Mar

ket

A

ttr

acti

ven

es s

McKinsey —General Electric portfolio matrix

1. The attractiveness of the market or industry is indicated by such factors as the size and growth of the market, ease of entry, degree of competition, and industry profitability for each strategic business unit.

2. Business strength is indicated by a firm’s market share and its growth rate, brand loyalty, profitability and technological and other comparative advantages.

3. Such analysis leads to three basic strategies:

1) Invest in and strengthen businesses operating in relatively attractive markets.

2) Where the market is somewhat less attractive and the business less competitive, the business strategy is one of getting the maximum out of existing resources.

McKinsey —General Electric portfolio matrix

3) The remaining businesses have little strategic quality and may, in the long term, be run down or divested unless action can be taken to improve their attractiveness.

An alternative analysis is the Boston Consulting Group approach, which describes the business portfolio in terms of relative market share and rate of growth as shown in figure-2.

Investment Strategy interms of relative market share and market growth

‘STARS’(Invest)

‘QUESTIONMARKS’(Invest)

‘CASH COW’(Funds Source)

‘DOGS’

LOWHIGH

HIGH

LOW

Divest

Relative Market Share

Market

Growth