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Chapter-2Chapter-2 (Strategy and Resource Allocation)(Strategy and Resource Allocation)

Submitted To:

Rowshanara Islam

Assistant Professor Department Of FinanceJagannath University

Submitted By:

Md. Abul Kashem

ID: 115202On behalf of group no- 023rd year 2nd semester (6th Batch)Department of FinanceJagannath University

Submission Date: 23Submission Date: 23rdrd September,2014 September,2014

Group Members List

No.No. NameName IDID

1 Md. Abul Kashem 115202

2 Md. Ismaile Hossain 115235

3 Mahmudul Hasan 115268

4 Mufty Anupama Parvin 115275

5Mohmmad Mahabubur Rahaman

B-110203019

6 Saidur Rahman Munna B-110203043

7 Riadh Mohammed Arif B-110203044

8 Md. Saleh Rabbi Monir B-110203054

9 Md. Kowshik Talukder B-110203089

10 Noor E Jannath B-110203119

After studying this chapter we will be able to

Show schematically how strategies are formulated. Describe different types of strategies. Explain how conglomerates can add value. Discuss various tools of portfolio planning. Show how the corporate centre can add value. Describe the various ways in which businesses compete.

The key responsibility of top management is concerned with capital allocation decisions. Capital is scarce and must be allocated across competing claims very judiciously. Mike Kaufman says, “The selection of the investment projects and the allocation of corporate capital to them are among top management’s primary responsibilities to shareholders. A good corporate investment program can mean sustained growth; failure to invest wisely can impede growth or threaten company survival.”

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. Richard Bower said in his perceptive work Managing the Resource Allocation Process that the set of problems firms refer to as capital budgeting is “a task for general management rather than financial specialists.”

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

Alfred D. Chandler, Jr, a Harvard professor, defined strategy as “the determination of the basic long-term goals and objectives of an enterprise, and the adoption of courses of action and the allocation of resources necessary for carrying out those goals.”

Apart from looking at the optimal fit between the capabilities of the firm and the opportunities in the environment, strategic planning also considers the following:

The complementarities and synergies between the existing assets and growth opportunities (the cross-sectional relationships).

The relationship between current growth opportunities and future growth opportunities (the time-series relationships).

The impact of new investments on the overall riskiness of the firm (the risk profile of the firm).

Environmental Analysis

CustomersCompetitorsSuppliersRegulationInfrastructureSocial/political environment

Firm’s Strategies

Opportunit ies and Threats

Identify opportunities

Find the fit between core capabilities and external

opportunities

Strengths and Weaknesses

Determine core capabilities

Internal Analysis

Technical knowhowManufacturing capacityMarketing and distribution capabilityLogisticsFinancial resources

Exhibit: Formulation of Strategies

Mahmudul HasanMahmudul Hasan ID- 115268ID- 115268

Grand StrategyGrand Strategy

The thrust of the overall strategy or ‘grand strategy’ of the firm may be on growth,stability, or conteaction as shown bellow:

Generally, companies strive for growth in revenues, assets and profits. The growth strategies are:

•Concentrationwhen a company anticipates growth in the market size of its product range or an increase in the market share enjoyed it in its product range is concentration. For example: Mc Donald’s in fast food, Microsoft in computer software and related products, Hero Honda in two wheels aggressively pursued this strategy.

• Ver tical Integration : vertical integration may be two types: a) Backward IntegrationBackward integration involves manufacturing of raw materials and

components required for the existing operation of the economy

b) Forward Integration:Forward integration involves the manufacture of products which use the

existing products of the company as input.Most of the oil companies like Exxon-Mobil, and British petroleum are

vertically integrated

• Diversif ication:

Diversification means entering a new business that is different from the current business.

a) Concentric Diversification b) Conglomerate Diversification

Concentric Diversif icationConcentric diversification, involves getting into a related business. such as , a

detergent manufacturer may inter into motor cycles .it has several advantages :

 All products may be benefit from the market image of the company.A common distribution network may be employed.Certain manufacturing facilities may be utilized.

Conglomerate Diversif icationConglomerate diversification, a form gets into a new business which is unrelated

to its existing business. Such as ITC Ltd ,a cigarette manufacturer .entered the field of hotels. It has also some advantages :

  Overcome the limited growth –opportunities in the existing line of business. Reduce the overall risk exposure of the firm.

A firm may follow a stability strategy if it is satisfied in serving the same product market segment and has no inclination to expand or diversify.

Contraction is the opposite of growth. It may be affected through divestiture or liquidation.Divestiture involves sale of a business unit of one firm to another.When a business is consistently underperforming and there is no hope of reviving or rehabilitating within reasonable period, liquidation may the only option. When the business is “Better dead than alive’’ steps must be taken to liquidate it.

Strategy Principal MotivationLikely outcomes

Profitability Growth Risk

Concentration

Vertical integration

Concentric diversificationConglomerate diversification

StabilityDivestment

-Ability to serve a growing market-Familiarity with technology and market-Cost leadership

-Greater stability for existing and proposed operations-Grater market power-Improve utilization of recourses-Limited scope in the present business-Satisfaction with status quo -Inadequate profit-Poor strategy

High Moderate Moderate

High Moderate Moderate

High Moderate Moderate

Moderate High Low

High Low Low High Low Low

Md. Ismaile HossainMd. Ismaile Hossain

ID- 115235ID- 115235

There are mainly individual corporations around the world and these are organized as portfolios of business units. Some examples are General Electric, Unilever, Sony Corporation, Reliance Industries etc. Portfolio companies have had a patchy record and conglomerate diversification is considered to be a highly controversial investment strategy.

Conglomerate Diversification helps a company in reducing its overall risk exposure.It is desirable that there are at least two or three distinct lines of business in a firm’s portfolio.It expands opportunities for growth.Such opportunities are more in newly emerging industries and they may be very different from the firm’s existing businesses.

Conglomerate Diversification

Though it is a good device for reducing exposure and widening growth possibilities, it more often than not tends to dampen average profitability.

Michael Gort who conducted a study for the National Bureau of Economic Research in the US found that unrelated diversification is not positively correlated with profitability.

Richard Rumelt reached the following conclusion- “Companies which branch out somewhat yet stick very close to their central skill, outperform all others”.

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A

B

A+BROI

Diversification and risk reduction

In 1960s and 1970s, the wave of diversification swept the industrial world in the western countries and conglomerate increased from 50 to 80 percent. The factors in favour of diversification were-•A desire to add second and third legs to one’s company to overcome cyclical fluctuations.•The argument of the Bostom Consulting group that no company was safe unless it had a portfolio consisting of at least three different kinds of businesses.•An inexorable desire of many companies to gradually get out of certain industries and move into newer ones.

Back to Basics:

While the companies succeeded in related diversification during 1960s and 1970s, they failed in unrelated diversification during 1980s. So many companies seem to be pursuing the strategy of going “Back to Basics”. Some examples are- •United Biscuits dropped its fast food restaurants to concentrate on biscuits and food products.•British Petroleum sold its world coal interests to concentrate on oil.Revival of diversification:

Interestingly, from 1990s onward corporate have begun to adopt the strategy of diversification worldwide. But without diversifying into unrelated diversification, the companies diversify into related business during 1990s or at least into businesses in which the strengths of a particular management team fits the need of the new business being added to the corporation.

Products Markets: Buyers and sellers in the emerging markets suffer from informational handicaps. Due to lack of information, companies have to incur substantial costs for establishing credible hands. In such an environment, a conglomerate with a good track record has a natural advantage. The cost incurred can be spread across multiple lines of business.

Capital Markets: Capital markets in developing markets are weak, deficit and inadequate. So, investors are reluctant to invest. Here diversified groups have an advantage as they can inspire confidence in investors. They enjoy superior ability to raise capital over smaller companies.

Labour Markets: There is often a shortage of well trained people in labour markets in developing countries.A conglomerate group can overcome problems by instituting training programmes human capital, by shifting manpower from declining ventures to growing businesses.

Regulation: Often regulatory provisions give considerable discretion to bureaucrats.A diversified conglomerate seems to have an advantage in coping with such a regulatory environment. The larger the conglomerate, the easier it is to maintain govt. relationship.

Contract Enforcement: Judicial processes are inordinately slow and may be vitiated may not be able to resolve disputes satisfactorily.Conglomerates who have built a reputation have an edge. All the groups companies have credibility when they promise to honour their agreements with any single partner.

Mohmmad Mahabubur RahamanMohmmad Mahabubur Rahaman

ID- B110203019ID- B110203019

According to economists and management scholars, firms resort to different types of diversification to cope with different types of market failure.  Unrelated diversification :The corporate structure can potentially improve governance. Companies like General Electric have succeeded in unrelated diversifications because of governance economies.

Vertical integration :Around the turn of twentieth century, many U.S firms were compelled to by way of vertical integration because of there are no outside suppliers of critical products and services. Missing markets prodded vertical intregration.It captures coordination economies.

Related diversification : it helps a firm overcome a failure in the resource market. since related diversification involves in broadening the scope of a firms activities, it captures scope economies.

Strategic diversification : it involves creating real options that enable a firm to peruse new strategic opportunities. It generates option economies.

To sum up, diversification, in different forms, can help creating value by addressing different kinds of market failure as shown below :

Related diversif ication can create diversif ication for shareholders for the fol lowing factors:

Managerial economies of scale Higher debt capacity Lower tax burden Larger internal capital Unprofitable investment

Compulsion for conglomerate diversif ication:  Restriction in growth in the existing l ines of business, often arising from governmental

refusal to expansion proposal. Vulnerabil ity to changes on government policies with respect to imports , duties , pricing

, and reservations. Opening up newer areas of investments in the wake of l iberl isations. Cyclicality of the main l ine of business leading to wide fluctuations in sales and profits

from the year. Beside to avail tax incentives mainly in the form of investment allowance and large

initial depreciation write-of fs. A self image venture sameness and versatil ity prodding companies to prove themselves

into newer fields A need to widen future options by entering newly emerging industries where the

potential seems enormous. 

Diversification also involves uncertainty. To reduce diversification it has to be approached systematicallyor rationally. Risk of diversification can be reduced if managers can find the answer of these questions:

What can our company do better than any of our competitors in our current markets? By indentifying what it excels at a company can improve the prospects of its success in new markets.

What strategic assets do we need in order to succeed in the new market? Managers must ascertain that the company has all the strategic assets required to gain a competitive

advantage in the new market. Can we catch up to or leapfrog competitors at their own game?

A company need not despair if it lacks some critical strategic assets. It can perhaps buy or develop or even render by altering the rules of competition.

Will diversification break up strategic assets that need to be kept together? Yes, some times diversification break up strategic assets that needs to be kept together.

Will we be simply a player in the new market or we emerge a winner? Competitors may imitate, or purchase, or even render unnecessary strategic assets on which the

diversifying company may be betting heavily.

What can our company learn by diversif ication, and are we suff iciently organized to learn it?

Smart companies derive valuable lessons from their diversification initiatives.

Conglomerate diversification generally dampens profitability and in some cases jeopardizes theexistence of the firm. Since it involves a journey to a relatively unfamiliar terrain it should be viewedwith circumspection. Some practical guidelines are:

1. If we lack financial sinews to sustain the new project during the learning period, avoid grandiose diversification project.

2. Realistically examine the critical skills and resources to succeed in the new line of business.3. Ensure that the diversification project has a good fit in terms of technology and market with the

existing business.4. Try to be the first or very early entrant in the field we diversifying into. This will protect us from

serious competitive threat in the initial years.5. Where possible adopt the following sequence – substantial sub-contracting - full blown

manufacturing.6. Seek partnership of other firms in areas where we are vulnerable or competitively weak.7. If the failure of the new project can threaten the company’s existence, float a separate company

to handle the new project.8. Remember that the meaningful conglomerate diversification represents the greatest challenge

to the corporate vision and leadership.9. Guard against bandwagon mentality and empire building tendencies.

Md. Saleh Rabbi MonirMd. Saleh Rabbi Monir ID- B110203054ID- B110203054

Portfolio planning tools have been developed to guide the process of strategic planning and resource allocation.

Three such tools are the- BCG MatrixThe General Electric’s Stoplight MatrixThe McKinsey Matrix

Developed by Boston Consult ing Group. The BCG matrix classif ied the various businesses in a f i rm’s por tfol io on the basis of relative market share and relative market-growth rate.

BCG matrix consists of four cel ls with market share on the horizontal axis and market growth rate on the ver tical axis.

Mar

ket

gro

wth

rat

e

Market share

Stars Question Marks

Cash cows Dogs

Hig

hL

ow

High Low

Stars

Businesses which enjoys a high market share and a high growth rate are referred to as stars. Though they earns high profits, they require additional commitment of funds because of the need to make further investment investments for expanding for expanding their production and sales. Eventually, as growth declines and additional investment needs diminish, star become cash cows.

Question marks:

Business with high growth potential but low present market share are called question marks. Additional resources are required to improve their market share and potentially convert them into stars. Of course, there is no guarantee that his would happen- that is why they are called ‘question marks’

Cash cows:

Business which enjoy a relatively high market share but low growth potential are called cash cows. They generate substantial profits and cash flows but their investment requirements are modest. The cash surpluses provided by them are available for use elsewhere in the business.Dogs:

Business with low market share and limited growth potential are referred to as dogs. Since the prospects for such products are bleak, it is advisable to phase them out rather than continue with them.

It uses 3*3 matrix called General Electric’s stoplight’s Matrix to guide the allocation of resources. This matrix for evaluating the business of a firm in terms of two key issues:

Business strength Industry attractiveness

Stars Question marks

Cash cows( funds generated)

Dogs on divestment (funds released)

Part A

Part B

Stars Question marks

Cash cows Dogs

Saidur Rahman MunnaSaidur Rahman Munna

ID- B110203043ID- B110203043

It is very similar to the General Electric Matrix, and has two dimension Competitive position Industry attractiveness

General Electric’s Stoplight Matrix Business Strength

Invest Invest Hold

Invest hold Divest

Hold Divest Divest

Strong Average Weak

Industry

attractiveness

Good Medium poor

Winner Winner Question Mark

Winner Average Business Loser

Profit Producer Loser Loser

High

Medium

Low

Competitive position

Evaluation Portfolio planning models tend to over-simplify the analysis of alternativeness. Issues become more complex if the matrix is expanded to cover the possibilities of moderate market share and potential growth rate. Likewise, if factors other than profit returns and investment requirements are considered, greater complications arise. Notwithstanding these limitations, the basic idea of classifying products in terms of market share and potential market growth rate is very powerful. It helps the management in asking the right questions and examining relevant strategies.

Parenting Advantage

The classic approach to business portfolio management, Focuses on the overall attractiveness of the industry and the business’s competitive position within the industry. While the classic approach is inherently sound, it suffers from a limitation. It ignores the synergies between different businesses in the firm’s portfolio and assumes that the firm is the right owner for all its businesses. Since different skills are required for managing different businesses, it is necessary to go beyond business positioning and consider whether there is a good fit between the parent and the business unit.McKinsey and company recommends a more sophisticated approach to business portfolio management that consider parenting advantage along with the business unit’s inherent value creation potential.

NaturalOwner

Parent company’s ability to extract value from the business unit, relative to other potential owners

One of the pack

High Medium Low

Riadh Mohammed ArifRiadh Mohammed Arif

ID- B110203044ID- B110203044

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

How the Corporate Center can Add Value

According to Tom Copeland, Tim koller, and Jack murrin,the corporate center in a multibusiness company or group can add value in the following ways:

Industry Shaper Deal master Scarce Asset AllocatorSkill Replicator Performance Manager Talent AgencyGrowth Asset

According to C.K Prahald and Yves Doz there are Different ways of thinking relatedness as discussed below:

Business Selection Parenting Similarities Core Competencies Inter-business Linkage Complex Strategic Integration

Enhancing the Ef fectiveness of Por tfol io Management

Corporate Portfolio management is mainly concerned with deciding which business to own and which businesses to divest. A central issue in capital allocation, corporate portfolio management perhaps has the greatest impact on value creation.

Despite its significance, many companies do not manage their business manage portfolios optimally. It appears that there are three major barriers to effective portfolio management:

I . Measurement and Information ProblemsI I . Behavioral factorI I I . Corporate Governance and Incentives

Despite its significance, many companies do not manage their business manage portfolios optimally. It appears that there are three major barriers to effective portfolio management:

I . Measurement and Information ProblemsI I . Behavioral factorI I I . Corporate Governance and Incentives

Firms interested in enhancing the effectiveness of portfolio management will find the following suggestions helpful.Create a team of independent people reviewImprove the quality of informationDevelop processes for thinking about alternativesLook outside the company

 

Among various models that can be used as frameworks for developing a business level strategy, there are three generic strategies that can be adopted at the business unit level Cost leadership Differentiation FocusAnother strategy that that has gained recognition in recent years is the Network Effect Strategy

Cost Leadership A business unit may seek to achieve a position of cost leadership as its principal weapon of competition. Cost leadership may be gained by exploting economies of scale, improving capacity utilisation, exercising tight control across the entire value chain, enhancing the productivity of R&D and marketing outlays, deriving advantage from cumulative learning, and simplifying the product/service design.The typical motto of a cost leader is to “offer a product of accepable quality at a low cost”

Dif ferentiation

A differentiation strategy involves offering a product or service that is perceived by customers as distinctive or unique so that they are expected to pay a higher price. To succeed in this strategy the firm must identify some attributes of a product or service that customers really value, position itself to serve the customer need in a unique manner, and offer the differentiated product or service profitably. It may be achieved through product quality, product range, bundled services, brand image, delivery convenience, and reputation. Many firms that pursue this strategy seek to “offer a superior product or service at an affordable price”

Focus

A strategy of focus involves concentrating on a narrow line of products or a limited market segment. In the selected target market the company seeks to gain a competitive edge through cost leadership (cost focus) or product differentiation (differentiation focus).

Cost focus A firm which pursues this strategy, concentrates on a narrow line of products or limited market

segment. Within this domain, it achieves cost leader ship through sustained efforts.

Differentiation focus A strategy of differentiation focus involves concentrating on a limited market segment wherein the

firm can offer a differentiated product based on its innovative capabilities.

Overalldifferentiation

Overall Cost Leadership

FocusedDifferentiation

Focused CostLeadership

Broad(Industry-wide)

Narrow

(Segment only)

Strategic Scope

Sources of competitive advantageUnique value as perceived by customer

Lowest cost

Network ef fect strategy

Network effect is referred that the value of a product or service is increase as more and more people use it. Success with the network strategy depends on the ability of a company to lead the charge and establish a dominant position. When a company does so, there is very little space available for others. That is why the network effect strategy is also called the winner-take-all strategy.

Achieving and Sustaining Competit ive Advantage

A firm does not achieve and sustain competitive advantage by merely choosing a competitive strategy. It has to make necessary commitments to develop the required core competencies and structure its value chain efficiently. “The uniqueness of a firm’s core competencies and its value chain and the extent to which it is difficult for competitors to imitate them determines the sustainability of a firm’s competitive advantage.”

Capital expenditures, par t icularly the major ones, are supposed to observe the strategy of the f irm. Hence, the relationship between strategic planning and capital budgeting must be properly recognized.

Capital Budgeting

Product Strategy, market Strategy, Production Strategy, and So on

Any Question?Any Question?

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