Chapter 7 Corporate Strategy and Capital Budgeting Decision

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Chapter 7Corporate Strategy and Capital
Budgeting Decision

• Capital Budgeting and Investment Analysis by
  Shapiro

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Introduction

• 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 opportunities

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Competitive markets and excess returns

• 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

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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

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Barriers to entry and positive NPV projects

• 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

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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 cost
• There are inherent cost advantages to being large
• 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

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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

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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.

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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

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Cost advantages cont.

• Monopoly control of low cost raw materials is
  another cost advantage open to entrenched firms
• Favorable locations are important to fast food
  restaurants and supermarkets

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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 proprietary

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Product differentiation

• It can stem from investments in advertising, RD
  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 companys reputation for quality and integrity
  permits it to charge a premium price for a
  quality product or service

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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 customers
• Pharmaceutical companies earn high returns by
  developing unique products protected from
  competition by patents, trademarks and brand names

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Product differentiation cont.

• Development of technologically innovative
  products
• Service is the key to extraordinary profitability
  to many firms
• Selling solutions to their customers problems

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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

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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

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Lesson 4

• Investments devoted to gaining better product
  distribution often lead to higher profitability

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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.

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Lesson 6

• A companys 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

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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

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Designing an investment strategy cont.

• 2. Develop the highest product/quality
  differentiated position within the industry,
  while maintaining an acceptable delivered cost
  structure

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Corporate strategy and foreign investment

• 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 RD,
  production, brand awareness, and distribution

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• World scale large volume if firms expand
  overseas. Size necessary in certain industries to
  compete effectively in the global market place
• 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

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Designing a global expansion strategy

• 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

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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)