resource allocation and investment strategies

8/8/2019 Resource Allocation and Investment Strategies

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Strategy

&Capital Budgeting


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Strategy and Capital allocation

Capital budgeting is not the exclusive

domain of financial analysts, it is a

multifunctional task linked to a firmsoverall strategy.

Growth Strategies Expansion,

Modernisation, Diversification, Merger &Acquisitions

Allocation of Capital- As per Long Term

Strategies


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Objectives

What should be the strategic posture of the

firm for Growth ?

What pattern of resource allocation

subserves the chosen strategic posture ?


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Key Criteria

Increase in Shareholders Wealth is reflected

in :

Profitability - ROE = PAT / Net worth Risk- How much do individual outcomes

deviate from the expected value ? Risk interms ofRange of ROE

Growth Compounded rate of growth ofPAT


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Generic Strategies and Key

O

ptions Aggressive Concentric Diversification,

Concentration & Vertical Integration

Competitive Concentric Merger,ConglomerateMerger & Turnaround

Conservative Status Quo,Diversification &

Conglomerate Diversification

Defensive Divestment, Liquidation andRetrenchment


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Portfolio Planning Tools

Boston Consulting Group (BCG) Product

Portfolio Matrix

General Electrics Stoplight Matrix

Strategic Position And Action Evaluation

( SPACE)


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BCG Product Portfolio Matrix

Product Analysis on the basis of :

(a) Relative Market Share

(b) Industry Growth Rate

Stars

Question Marks

Cash Cows

Dogs


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BCG Product Portfolio Matrix

Relative Market Share

Industry

Growth

Rate

High Low

High Stars Question

marks

Low Cash

Cows

Dogs


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Stars

Products having high market share andhigh growth rate

Earn high profits and require additionalcommitment of funds for increasingproduction and sales.

As growth declines,additional investment

is not required and stars become cashcows.


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Question Marks

High Growth Potential but low market

share

Additional resources for improving marketshare and potentially converting them into

stars

But there is no guarantee that this wouldhappen. Thus, the question mark.


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Cash Cows

High Market Share but low growth

potential

Generate substantial profit and cash flowswith modest investment requirements

Cash surpluses provided by them are used

elsewhere in the business


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Dogs

Low market share and limited growth

potential

Since prospect is bleak,phasing out of theproduct is advised.


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Resource A ocat on

(Suggested Pattern)

Funds generated by Cash Cows should be

allocated to Stars and Question Marks

Funds released on divestment of Dogs

should be pooled and again allocated to therequirements of Stars and Question Marks.


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General Electrics Spotlight

MatrixStrong Average Weak

High Invest Invest Hold

Medium Invest Hold Divest

Low Hold Divest Divest


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Example

Rail Transportation as an industry hasmedium to low potential of growth & un-remunerativeness of any branch lines is anindicator of weak business strength. Forsuch branch lines, decision for divestment /strategic sale / leasing out etc. should beforced.

Whereas for Golden Quadrilateral, Industrypotential is High as well as for bulk trafficbusiness strength is high, hence we shouldinvest more here.


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Strategic Position And Action

Evaluation ( SPACE)

A Four Dimensional approach :

Companys Competitive Advantage

Companys Financial Strength

Industry Strength

Environmental Stability


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Company Competitive

Advantage Market Share

Product Quality & Life Cycle

Product Replacement Cycle

Customer Loyalty

Competitors capacity utilisation

Technological Know-how

Vertical Integration


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Companys Financial Strength

Return on Investment

Leverage

Liquidity

Capital Required / capital available

Cash Flow

Ease of exit from market

Risk involved in the business


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Industry Strength

Growth & Profit Potential

Financial Stability

Technological Know-how

Resource Utilisation

Capital Intensity

Ease of Entry into market

Productivity, Capacity Utilisation


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Environmental Stability

Technological Changes

Rate of Inflation

Demand Variability

Price range of competing products

Barriers to entry into market

Competitive pressure

Price Elasticity of Demand


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Scale of Assessment

For Companys Financial Strength and

Industry Strength, 0 to 7,with 0 reflecting

the most unfavourable assessment and 7the most favourable.

For Companys Competitive Advantage

and Environmental Stability ,0 to 7

,with0 reflecting the most favourable

assessment and 7 the most unfavourable


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Steps to Assessment

Plot the values on the four-dimensionalgraph

Average the numerical values to get thenumerical score for the dimension

Plot the scores for the four dimensions ofthe axes of the SPACE chart.

Connect the scores so plotted to get afour-sided polygon, reflecting the sizeand direction of the assessment.


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Strategic Postures

Aggressive Posture ( or Michael Porters OverallCost Leadership)

Competitive Posture ( or Michael PortersProduct Differentiation)

Conservative Posture( or Michael PortersFocus)

Defensive Posture ( or Michael PortersGamesmanship)


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Aggressive Posture

For companies which

enjoys competitive advantage

have considerable financial strength

belongs to an attractive industry, and

operates in a relatively stable environment

(Firm must fully exploit opportunities available to

it,look for acquisition possibilities, concentrateresources to maintain its competitive edge,and

enhance its market share.)


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Competitive Posture

For companies which enjoys competitive advantage

has limited financial strength

belongs to an attractive industry, and operates in a relatively unstable

environment

(Firm should enhance competitive advantage byproduct improvement and differentiation,widenthe product line,improve marketingeffectiveness and augment financial resources)


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Conservative Posture

For companies which

enjoys financial strength

has limited competitive advantage

belongs to a not-so-attractive industry,and operates in a relatively stable

environment

(Firm should prune non-performingproducts,reduce costs,improveproductivity,develop new products andaccess more profitable markets.)


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Defensive Posture

For companies which:

lacks competitive advantage

lacks Financial Strength belongs to a not-so-attractive industry,and

operates in a relatively stable environment

(Firm should discontinue unviable

products,control costs aggressively,monitor

cash flows strictly,reduce capacity and limit

investments.)


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Conglomerate Diversification

Diversification in Unrelated Areas.

Firms plan to increase their product lines.

They control a range of activities invarious industries that require different

skills in the specific managerial functions

of research, applied engineering,production, marketing and so on.

Can be achieved mainly by external

acquisition/merger


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Benefits of Con. Diversification

Reduces overall risk exposure and risk of

cyclicality

Expands opportunities for growth from

saturation to emerging industries in the life

cycle of the business.


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Cons of Conglo. Diversification

Reduces average profitability unrelated

diversification is not positively correlated

with profitability.

Organisations that stick very close to the

original business outperform others.


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Interface between Cap. Bud. and

Strategic Planning

Capital budgeting should be squarely

related to the corporate strategy

It should sub serve the strategy of the firm


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Investment Decisions under

Inflation Executives generally estimate cash flows

assuming unit costs and selling price prevailingin year zero to remain unchanged.

They argue that if there is inflation, prices can beincreased to cover increasing costs; therefore, theimpact on the projects profitability would be thesame if they assume rate of inflation to be zero.

This line of argument, although seems tobe convincing, is fallacious for tworeasons.


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Two Reasons

First, the discount rate used for discounting cash flowsis generally expressed in nominalterms. It would beinappropriate and inconsistent to use a nominal rate to

discount constant cash flows.

Second, selling prices and costs show differentdegrees of responsiveness to inflation:

The depreciation tax shield remains unaffected byinflation since depreciation is allowed on the bookvalue of an asset, irrespective of its replacement ormarket price, for tax purposes.


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What to do ?

We should be consistent in treatinginflation since the discount rate is marketdetermined it is stated in nominalterms.Thus the cash flows should also beexpressed in nominal terms.

In other words,cash flows should reflect effect ofinflation,when they are discounted by theinflation affected discount rate.


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Financing Effects in Investment

Evaluation According to the conventional capital budgeting

approach cash flows should not be adjusted for thefinancing effects.

The adjustment for the financing effect is made inthe discount rate. The firms weighted average costof capital (WACC) is used as the discount rate.

It is important to note that this approach of

adjusting for the finance effect is based on theassumptions that: The investment project has the same risk as the firm.

The investment project does not cause any change in the

firms target capital structure.


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Thanks

resource allocation and investment strategies

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