Corporate Strategy and the Capital Investment Decision

1
Corporate Strategy and the Capital Investment
Decision

• By
• Mahmood Osman Imam
• Department of Finance
• University of Dhaka

2
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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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McKinsey General Electric portfolio matrix
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McKinsey General Electric portfolio matrix

• 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.
• Business strength is indicated by a firms market
  share and its growth rate, brand loyalty,
  profitability and technological and other
  comparative advantages.
• 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.

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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.

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Investment Strategy interms of relative market
share and market growth
Relative Market Share
Market Growth
Divest