CHAPTER 2

STRATEGY AND CAPITAL ALLOCATION

Concept of strategy

Grand strategy

Diversification debate

Portfolio strategy

Business level strategy

Strategic planning and capital budgeting

OUTLINE

Concept of Strategy

Chandler defined strategy as “the determination of the basic long-Chandler defined strategy as “the determination of the basic long-

term goals and objectives of an enterprise, and the adoption of term goals and objectives of an enterprise, and the adoption of

courses of action and the allocation of resources necessary for courses of action and the allocation of resources necessary for

carrying out the goals.”carrying out the goals.”

Strategy involves matching a firm’s ‘strengths’ and ‘weaknesses’ Strategy involves matching a firm’s ‘strengths’ and ‘weaknesses’

with the ‘opportunities’ and ‘threats’ present in the external with the ‘opportunities’ and ‘threats’ present in the external

environment.environment.

Formulation of Strategies

Environmental Analysis

CustomersCompetitorsSuppliersRegulationInfrastructureSocial/political environment

Internal Analysis

Technical know-howManufacturing capacityMarketing and distribution capabilityLogisticsFinancial resources

Opportunities and threats

Identify opportunities

Strengths and weaknesses

Determine core capabilities

Find the fit between core capabilities and external opportunities

Firm’s strategies

Diversification

Grand Strategy

Growth ContractionStability

Concentration Vertical integration

Liquidation Divestiture

The Thrust of Grand Strategy

Strategies, Principal Motivations, and Likely Outcomes Principal Likely Outcomes

Strategy Motivations Profitability Growth Risk

Concentration - Ability to serve a High Moderate Moderate

growing market

- Familiarity with technology

and market

- Cost leadership

Vertical integration - Greater stability for existing High Moderate Moderate and proposed operations

- Greater market power

Concentric - Improves utilisation of High Moderate Moderate

diversification resources

Conglomerate - Limited scope in the present Moderate High Low

diversification business

Stability - Satisfaction with status quo High Low Low

Divestment - Inadequate profit High Low Low

- Poor strategy

A

B

(A+B)

ROI

Diversification Debate

Pros and Cons

Reduces overall risk exposure

Expands opportunities for growth

Dampens profitability

Diversification and Risk Reduction

Why Conglomerates Can Add Value in Emerging Markets

Khanna and Palepu believe that while focus makes eminent sense in the west, conglomerates have certain advantages in emerging markets which are characterised by institutional weaknesses in the following areas :

Product markets

Capital markets

Labour markets

Regulation

Contract enforcement

Diversification and Value Creation

Market FailureMarket Failure Form of Form of DiversificationDiversification

Source of Value Source of Value AdditionAddition

Capital marketsCapital markets Unrelated Unrelated diversificationdiversification

Governance Governance economieseconomies

Product marketsProduct markets Vertical integrationVertical integration Coordination Coordination economieseconomies

Resource marketsResource markets Related diversificationRelated diversification Scope economiesScope economies

Risk marketsRisk markets Strategic Strategic diversificationdiversification

Option economiesOption economies

Diversification – A Mixed Bag

PositivesPositives NegativesNegatives

Managerial economies of Managerial economies of

scalescale

Dissipation of managerial Dissipation of managerial

focusfocus Higher debt capacityHigher debt capacity Unprofitable investment.Unprofitable investment.

Lower tax burdenLower tax burden

Larger internal capital Larger internal capital

Compulsions for Conglomerate Diversification in India

Restriction in growth in the existing line of business, often arising from governmental Restriction in growth in the existing line of business, often arising from governmental refusal to expansion proposals.refusal to expansion proposals.

Vulnerability to changes in governmental policies with respect to imports, duties, Vulnerability to changes in governmental policies with respect to imports, duties, pricing, and reservations.pricing, and reservations.

Opening up of newer areas of investments in the wake of liberalisation.Opening up of newer areas of investments in the wake of liberalisation.

Cyclicality of the main line of business leading to wide fluctuations in sales and profits Cyclicality of the main line of business leading to wide fluctuations in sales and profits from year to year.from year to year.

Bandwagon mentality which has been induced by years of close regulation of Bandwagon mentality which has been induced by years of close regulation of industrial activity.industrial activity.

Desire to avail of tax incentives mainly in the form of investment allowance and large Desire to avail of tax incentives mainly in the form of investment allowance and large initial depreciation write-offs.initial depreciation write-offs.

A self-image of venturesomeness and versatility prodding companies to prove A self-image of venturesomeness and versatility prodding companies to prove themselves in newer fields.themselves in newer fields.

A need to widen future options by entering newly emerging industries where the A need to widen future options by entering newly emerging industries where the potential seems enormous.potential seems enormous.

How to Reduce the Risks in Diversification

Markides argues that the risk of diversification can be mitigated if managers address the following questions:

What can our company do better than any of its competitors in its What can our company do better than any of its competitors in its current market?current market?

What strategic assets do we need in order to succeed in the new What strategic assets do we need in order to succeed in the new market?market?

Can we catch up to or leapfrog competitors at their own game?Can we catch up to or leapfrog competitors at their own game? Will diversification break up strategic assets that need to be kept Will diversification break up strategic assets that need to be kept

together?together? Will we simply be a player in the new market or will we emerge a Will we simply be a player in the new market or will we emerge a

winner?winner?

What can our company learn by diversifying and are we sufficiently What can our company learn by diversifying and are we sufficiently organised to learn it?organised to learn it?

Guidelines for Conglomerate Diversification

1.1. If you lack financial sinews to sustain the new project during the ‘learning If you lack financial sinews to sustain the new project during the ‘learning period’, avoid grandiose diversification projects.period’, avoid grandiose diversification projects.

2. 2. Realistically examine whether you have the critical skills and resources to succeed Realistically examine whether you have the critical skills and resources to succeed in the new line of business.in the new line of business.

3.3. Ensure that the diversification project has a good fit in terms of technology and Ensure that the diversification project has a good fit in terms of technology and market with the existing business.market with the existing business.

4.4. Try to be the first or a very early entrant in the field you are diversifying into. Try to be the first or a very early entrant in the field you are diversifying into. This will protect you from serious competitive threat in the initial years.This will protect you from serious competitive threat in the initial years.

5.5. Where possible adopt the following sequence: marketing – substantial sub-Where possible adopt the following sequence: marketing – substantial sub-contracting – full blown manufacturing.contracting – full blown manufacturing.

6.6. Seek partnership of other firms in areas where you are vulnerable or competitively Seek partnership of other firms in areas where you are vulnerable or competitively weak.weak.

7.7. If the failure of the new project can threaten the company’s existence, float a If the failure of the new project can threaten the company’s existence, float a separate company to handle the new project.separate company to handle the new project.

8.8. Remember that meaningful conglomerate diversification represents the greatest Remember that meaningful conglomerate diversification represents the greatest challenge to corporate vision and leadership.challenge to corporate vision and leadership.

9.9. Guard against bandwagon mentality and empire-building tendencies.Guard against bandwagon mentality and empire-building tendencies.

Portfolio Strategy

In a multi-business firm, allocation of resources across various businesses is a key strategic decision. Portfolio planning tools have been developed to guide the process of strategic planning and resource allocation. Three such tools are the BCG matrix, the General Electric’s stoplight matrix, and the Mckinsey matrix.

BCG Matrix

High Low

Low

Hig

h

M a r k e t G r o w t h R a t e

StarsQuestion

Marks

CashCows

Dogs

Market Share

Pattern of Capital Allocation

Stars Question marks

Cash cows Dogs on divestment(funds generated) (funds released)

Stars Question marks1 Cash cows Dogs

Part A

Part B

General Electric’s Stoplight Matrix

Business Strength

H i g h

M e d i u m

L o w

Attractiveness

Industry

Invest

Invest Hold

DivestHold

Invest Hold

Divest

Divest

Strong Average Weak

McKinsey Matrix

Very similar to the General Electric Matrix, the McKinsey matrix has two dimensions, viz competitive position and industry attractiveness. The criteria or factors used for judging industry attractiveness and competitive position along with suggested weights for them are as follows:

Industry Attractiveness Competitive Position

Criteria Weight Key Success Factors Weight

Industry size 0.10 Market share 0.15

Industry growth 0.30 Technological know how 0.25

Industry profitability 0.20 Product quality 0.15

Capital intensity 0.05 After-sales service 0.20

Technological stability 0.10 Price competitiveness 0.05

Competitive intensity 0.20 Low operating costs 0.10

Cyclicality 0.05 Productivity 0.10

Assessment of the SBU Factory Automation

Industry Attractiveness 

Criteria Weight Rating Weighted Score

Industry size 0.10 4 0.40Industry growth 0.30 4 1.20Industry profitability 0.20 3 0.60Capital intensity 0.05 2 0.10Technological stability 0.10 2 0.10Competitive intensity 0.20 3 0.60Cyclicality 0.05 2     

Competitive Position 

Key Success Factors Weight Rating Weight Score

Market share 0.15 4 0.60Technological know how 0.25 5 1.25

Product quality 0.15 4 0.60After-sales service 0.20 3 0.60Price competitiveness 0.05 4 0.20Low operating costs 0.10 4 0.40Productivity 0.10 5     

0.103.10

0.504.15

Attractiveness

  Good Medium Poor

High Winner Winner Question Mark

Medium Winner Average Business Loser

Low Profit Producer Loser Loser

Industry

The McKinsey Matrix

Competitive Position

Market-Activated Corporate Strategy (MACS) Framework

Source: McKinsey & Company

How the Corporate Centre Can Add Value*

 

According to Tom Copeland, Tim Koller, and Jack Murrin, the corporate centre in a

multibusiness company or group can add value in the following ways:

Industry shaper Industry shaper It acts proactively to shape an emerging industry to its advantage. It acts proactively to shape an emerging industry to its advantage.

Deal Maker Deal Maker It spots and executes deals based on its superior insights.It spots and executes deals based on its superior insights.

Scarce Asset Allocator Scarce Asset Allocator It allocates capital and other resources efficiently across different It allocates capital and other resources efficiently across different businesses.businesses.

Skill Replicator Skill Replicator It facilitates the lateral transfer of distinctive resources.It facilitates the lateral transfer of distinctive resources.

Performance Manager Performance Manager It instills a high performance ethic with appropriate It instills a high performance ethic with appropriate measurement systems and incentive structures.measurement systems and incentive structures.

Talent Agency Talent Agency It attracts, retains, and develops talent.It attracts, retains, and develops talent.

Growth Asset Allocator Growth Asset Allocator It leads innovation in multiple businesses.It leads innovation in multiple businesses.

* Adapted from Tom Copeland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the * Adapted from Tom Copeland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the

Value of Companies, New York: John Wiley and Sons, 2000, P.94 Value of Companies, New York: John Wiley and Sons, 2000, P.94

Portfolio Configuration

Identifying the appropriate configuration of business portfolio is Identifying the appropriate configuration of business portfolio is perhaps the most important task of top management. It calls for perhaps the most important task of top management. It calls for an insightful assessment of the logic of relatedness among an insightful assessment of the logic of relatedness among various businesses in the portfolio.various businesses in the portfolio.

According to C.K. Prahalad and Yves Doz there are different According to C.K. Prahalad and Yves Doz there are different ways of thinking about relatedness:ways of thinking about relatedness:

Business selectionBusiness selection

Parenting similaritiesParenting similarities

Core competenciesCore competencies

Interbusiness linkagesInterbusiness linkages

Complex strategic integrationComplex strategic integration

Barriers to Effective Corporate Portfolio Management - 1

Corporate portfolio management perhaps has the greatest impact on Corporate portfolio management perhaps has the greatest impact on value creation.value creation.

Despite its significance, many companies do not manage their Despite its significance, many companies do not manage their business portfolios optimal.business portfolios optimal.

Three major barriers to effective corporate portfolio management Three major barriers to effective corporate portfolio management are:are:

• Measurement and information problemsMeasurement and information problems

• Behavioural factorsBehavioural factors

• Corporate governance and incentivesCorporate governance and incentives

Barriers to Effective Corporate Portfolio Management - 2

Measurement and information problemsMeasurement and information problems

Assuming that the growth pattern of a business is an “S” curve, the slope at any Assuming that the growth pattern of a business is an “S” curve, the slope at any point of the “S” curve may be regarded as a proxy for the expected return from that point of the “S” curve may be regarded as a proxy for the expected return from that point on.point on.

The practical problem, of course, is that it is very difficult to establish that you are The practical problem, of course, is that it is very difficult to establish that you are at an inflexion point.at an inflexion point.

Behavioural FactorsBehavioural Factors

Sunk cost thinkingSunk cost thinking

Loss aversionLoss aversion

Endowment effectEndowment effect

Status quo biasStatus quo bias

Corporate governance and incentivesCorporate governance and incentives

Despite understanding the logic of shareholder wealth maximisation, many Despite understanding the logic of shareholder wealth maximisation, many corporate boards and senior managements commit to other objectives.corporate boards and senior managements commit to other objectives.

Enhancing the Effectiveness of Corporate Portfolio Management

1. Create a team of independent people for portfolio review.

2. Improve the quality of information.

3. Develop processes for thinking about alternatives.

4. Look outside the company.

Business Level Strategies

Diversified firm’s don’t compete at the corporate level. Rather, a Diversified firm’s don’t compete at the corporate level. Rather, a business unit of one firm competes with a business unit of another.business unit of one firm competes with a business unit of another.

Among the various models that have been used as frameworks for Among the various models that have been used as frameworks for developing a business level strategy, the Porter’s generic model is developing a business level strategy, the Porter’s generic model is perhaps the most popularperhaps the most popular

According to Porter, there are three generic strategies that can be According to Porter, there are three generic strategies that can be adopted at the business unit level.adopted at the business unit level.

Cost leadership Cost leadership

DifferentiationDifferentiation

FocusFocus

Strategy of Cost Leadership:

Dell Computer Corporation

• Direct selling

• Built-to-order manufacturing

• Low cost service

• Negative working capital

Sources of Competitive Advantage:

Unique Value as Lowest Cost Perceived by Customer

Broad (industry-wide) Strategic Scope

Narrow (segment only)

Overall Overall CostDifferentiation Leadership

Focused Focused CostDifferentiation Leadership

Porter’s Generic Competitive Strategies

Network Effect Strategy Network effect: The value of a product or service increases as more and

more people use it.

Network strategy: Success with the network strategy depends on the ability

of a company to lead the charge and establish a dominant position.

• eBay

• Microsoft

Richard Luecke: “Thus since, most PCs operated with Windows, most new

software was developed for Windows machines. And because most software

was Windows-based, more people bought PCs equipped with the Windows

operating system. To date no one has broken this virtuous circle.”

Environmental assessment

Managerial vision,values, and attitudes

Corporate appraisal

Strategic plan

Capital budgeting

Product strategy, market strategy,

production strategy, and so on

Strategic Planning and Capital Budgeting

COSTLEADERSHIP

Aggressive

FOCUS

Conservative

Defensive

GAMESMAN- SHIP

Competitive

DIFFEREN- TIATION

FS

ES

CA IS

Concentric Diversification

Concentration

VerticalIntegration

ConcentricMerger

Conglomerate Merger

Turnaround

Status Quo

ConglomerateDiversification

Diversification

Divestment

Liquidation

Retrenchment

Generic Strategies and Key Options

SUMMARY

Capital budgeting is not the exclusive domain of financial analysts and Capital budgeting is not the exclusive domain of financial analysts and accountants. Rather, it is a multifunctional task linked to a firm’s overall strategy.accountants. Rather, it is a multifunctional task linked to a firm’s overall strategy.

Capital budgeting may be viewed as a two-stage process. In the first stage Capital budgeting may be viewed as a two-stage process. In the first stage promising growth opportunities are identified through the use of strategic promising growth opportunities are identified through the use of strategic planning techniques and in the second stage individual investment proposals are planning techniques and in the second stage individual investment proposals are analysed and evaluated in detail to determine their worthwhileness.analysed and evaluated in detail to determine their worthwhileness.

Strategy involves matching a firm’s “strengths” and “weaknesses” – its distinctive Strategy involves matching a firm’s “strengths” and “weaknesses” – its distinctive competencies with the “opportunities” and “threats” present in the external competencies with the “opportunities” and “threats” present in the external environment.environment.

The thrust of the overall strategy or ‘grand strategy’ of the firm may be on The thrust of the overall strategy or ‘grand strategy’ of the firm may be on growth, stability, or contraction.growth, stability, or contraction.

Generally, companies strive for growth in revenues, assets, and profits. The Generally, companies strive for growth in revenues, assets, and profits. The important growth strategies are concentration, vertical integration, and important growth strategies are concentration, vertical integration, and diversification.diversification.

While growth strategies are most commonly pursued, occasionally firms may While growth strategies are most commonly pursued, occasionally firms may pursue a stability strategy. pursue a stability strategy.

Contraction is the opposite of growth. It may be effected through divestiture or Contraction is the opposite of growth. It may be effected through divestiture or liquidation.liquidation.

Conglomerate diversification, or diversification into unrelated areas, is a very Conglomerate diversification, or diversification into unrelated areas, is a very popular but highly controversial investment strategy. Although a good device for popular but highly controversial investment strategy. Although a good device for reducing risk exposure and widening growth possibilities, conglomerate reducing risk exposure and widening growth possibilities, conglomerate diversification more often than not tends to dampen average profitability.diversification more often than not tends to dampen average profitability.

In western economies, corporate strategists have argued from the 1980s that the In western economies, corporate strategists have argued from the 1980s that the days of conglomerates are over and have preached the virtues of core competence days of conglomerates are over and have preached the virtues of core competence and focus. Many conglomerates created in the 1960s and 1970s have been and focus. Many conglomerates created in the 1960s and 1970s have been dismantled and restructured. Tarun Khanna and Krishna Palepu, however, believe dismantled and restructured. Tarun Khanna and Krishna Palepu, however, believe that while focus makes eminent sense in the west, conglomerates may have certain that while focus makes eminent sense in the west, conglomerates may have certain advantages in emerging markets which are characterised by many institutional advantages in emerging markets which are characterised by many institutional shortcomings.shortcomings.

In a multi-business firm, allocation of resources across various businesses is a key In a multi-business firm, allocation of resources across various businesses is a key strategic decision. Portfolio planning tools have been developed to guide the strategic decision. Portfolio planning tools have been developed to guide the process of strategic planning and resource allocation. Three such tools are the process of strategic planning and resource allocation. Three such tools are the BCG matrix, the General Electric’s stoplight matrix , and the Mckinsey matrix.BCG matrix, the General Electric’s stoplight matrix , and the Mckinsey matrix.

Diversified firms don’t compete at the corporate level. Rather, a business unit of Diversified firms don’t compete at the corporate level. Rather, a business unit of one firm competes with a business unit of another. Among the various models that one firm competes with a business unit of another. Among the various models that can be used as frameworks for developing a business level strategy, the Porter’s can be used as frameworks for developing a business level strategy, the Porter’s generic model is perhaps the most popular. According to Michael Porter, there are generic model is perhaps the most popular. According to Michael Porter, there are three generic strategies that can be adopted at the business unit level: cost three generic strategies that can be adopted at the business unit level: cost leadership, differentiation, and focus.leadership, differentiation, and focus.

Capital expenditures, particularly the major ones, are supposed to subserve the Capital expenditures, particularly the major ones, are supposed to subserve the strategy of the firm. Hence, the relationship between strategic planning and capital strategy of the firm. Hence, the relationship between strategic planning and capital budgeting must be properly recognised.budgeting must be properly recognised.