Chapter 7Corporate Strategy and Capital

Budgeting Decision

Capital Budgeting and Investment Analysis by Shapiro

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

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

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

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

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

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

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.

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

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

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

Product differentiation

• It can stem from investments in advertising, R&D 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 company’s reputation for quality and

integrity permits it to charge a premium price for a quality product or service

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

Product differentiation cont.

• Development of technologically innovative products

• Service is the key to extraordinary profitability to many firms

• Selling solutions to their customers problems

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

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

Lesson 4

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

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.

Lesson 6

• A company’s 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

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

Designing an investment strategy cont.

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

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 R&D, production, brand awareness, and distribution

• 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

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

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)