Module 1:Planning Analysis & Overview

Course Facilitator: Prof. Radhakrishna

Content of Module 1
of capital budgeting Levels of decision making objective. Resource Allocation Framework: Key criteria for allocation of resource elementary investment strategies portfolio planning tools strategic position and action evaluation aspects relating to conglomerate diversification interface between strategic planning and capital budgeting.
Phases

Capital Expenditure
It is also referred to as a capital

investment or capital project or just project is that it typically involves a current outlay (or current and future outlays) of funds in the expectation of stream of benefits extending far into the future.

Capital Budgeting
Capital

budgeting decision may be defined as Firms decisions to invest its current funds most efficiently in long term activities in anticipation of an expected flow of future benefits over a series of year. The firms capital budgeting decisions will include addition, disposition, modification and replacement of fixed assets.

Capital Investments: Importance

Long Term Commitment of Funds

Irreversibility
Substantial Outlays Long Term Effect on Effect on

Profitability

Capital Investments: Difficulties

Measurement Problems

Uncertainty
Temporal Spread

Types of capital Investments

(1) Types Of Assets a) Physical Assets b) Monetary Assets c) Intangible Assets (2) Types of Decisions a) Strategic investments b) Tactical Investments (3) Planning and control a) Mandatory Investments b) Replacement Investments c) Expansion Investments d) Diversification Investments e) R&D Investments f) Miscellaneous Investments

Phases of Capital Budgeting

Phase 1): Planning

Phase 2): Analysis

Phase 3): Selection

Phase 4): Financing

Phase 5): Implementation

Phase 6): Review

Levels of Decision Making

Gordon, Miller and Mintzberg defined 3 levels of

decision making: Operating Decisions Administrative Decisions Strategic Decisions

Levels of Decision Making

Questions? Operational Decisions Administrative Decisions Strategic Decisions

Where is the decision taken

How Structured is the Decision What is the level of resource commitment What is the time horizon

Lower Level Management

Routine and Structured Minor resource Short term

Middle Level Management

SemiStructured Moderate resource Medium term Balancing Equipment

Top Level Management

Unstructured Major resource

Long term Diversification Project

Type of CB Decision Minor Office Made Equipment

Objectives of Capital Budgeting

To ensure the selection of the possible profitable

capital projects. To ensure the effective control of capital expenditure in order to achieve by forecasting the long-term financial requirements. To make estimation of capital expenditure during the budget period and to see that the benefits and costs may be measured in terms of cash flow. To facilitate co-ordination of inter-departmental project funds among the competing capital projects. To ensure maximization of profit by allocating the available investible.

Feasibility Study

Facets of Project Analysis or Feasibility Study

Market Analysis

Technical Analysis
Financial Analysis Economic Analysis Ecological Analysis

Facets of Project Analysis- Market Analysis

Market analysis is concerned primarily with two questions: What would be the aggregate demand of the proposed product / service in future? What would be the market share of the project under appraisal? To answer the above questions, the market analyst requires a wide variety of information & appropriate forecasting methods. The kinds of information required are: Consumption trends in the past & the present consumption level Past & Present supply position Production possibilities & Constraints Imports & Exports Structure of competition Cost Structure Elasticity of Demand Consumer behavior, intentions, motivations, attitudes, preferences & requirements Distribution channels & marketing policies in use Administrative, technical, & legal constraints

Facets of Project Analysis- Technical Analysis

Technical analysis seeks to determine whether the

prerequisites for the successful commissioning of the project have been considered and reasonably good choices have been made with respect to location, size, process, etc. The important questions raised in technical analysis are: Whether the preliminary tests and studies have been done or provided for? Whether the availability of raw materials, power, and other inputs has been established? Whether the selected scale of operation is optional? Whether the production process chosen is suitable? Whether the equipment and machines chosen are appropriate? Whether the auxiliary equipments and supplementary engineering works have been provided for? Whether provision has been made for the site, building, and plant is sound?

Facets of Project Analysis- Financial Analysis

Financial analysis seeks to ascertain whether the proposed project will be financially viable in the sense of being able to meet the burden of servicing debt and whether the proposed project will satisfy the return expectations of those who provide the capital. The aspects which have to be looked into while conducting financial appraisal are: Investment outlay & cost of project Means of financing Cost of capital Projected profitability Break-even point Cash flows of the project Investment worthwhileness judged in terms of various criteria of merit Projected financial position Level of risk

Facets of Project Analysis- Economic Analysis

Economic analysis also referred to as social cost benefit analysis, is concerned with judging a project from the larger social point of view. In such an evaluation the focus is on the social costs and benefits of a project which may often be different from its monetary costs and benefits. The questions sought to be answered in social cost benefits. The questions sought to be answered in social cost benefit analysis are: What are the direct economic benefits & costs of the project measured in terms of shadow (efficiency) prices and not in terms of market prices? What would be the impact of the project on the distribution of income in the society? What would be the impact of the project on the level of savings & investment in the society? What would be the contribution of the project towards the fulfillment of certain merit wants like self-sufficient, employment and social order?

Facets of Project AnalysisEcological Analysis

Ecological analysis should be done particularly for major projects which have significant ecological implications like power plants and irrigation, schemes, and environmental polluting industries (like bulk drugs, chemicals, and leather processing). The key questions raised in ecological analysis are:
What is the likely damaged caused by the project to

the environment?

What is the cost of restoration measures required to

ensure that the damage to the environment is contained within acceptable limits?

Strategy
The word strategy

has entered in the field of management from the military services where it refers to apply the forces against an enemy to win a war. Originally, the word strategy ha s been derived from Greek, strategos which means generalship. The word as used for the first time in around 400 BC. The word strategy means the art of the general to fight in war. The dictionary meaning of strategy is the art of so moving or disposing the instrument of warfare as to impose upon enemy, the place time and conditions for fighting by one self.

Concept of Strategy
According to Alfred D. Chandler, strategy is the

determination of the basic long-term goals and objectives of an enterprise and the adoption of the courses of action and the allocation of resources necessary for carrying out these goals. Strategy involves matching a firms strengths and Weaknesses-its distinctive competencies-with the opportunities and threats present in the external environment (Kenneth R Andrews)

Environmental Analysis Customers, Competitors, Suppliers, Regulation, Infrastructure, Social/Political Environment

Internal Analysis Technical know-how, Manufacturing Capacity, Marketing and Distribution Capability, Logistics, Financial Resources

Opportunities and Threats (Identify Opportunities)

Strengths and Weaknesses (Determine Core Capabilities)

Find the fit between core capabilities and external opportunities Firm's Strategies Chart: Formulation of Strategies

Concept of Strategy

Concept of Strategy
Strategic Planning also considers the following:

The

Cross Sectional Relationship: The complementarities and synergies between the existing assets and growth opportunities. The time series relationships: The relationship between current growth opportunities and future growth opportunities. The risk profile of the firm: The impact of new investments on the overall riskiness of the firm.

Grand Strategy
Grand Strateg y

Growth

Stability

Contraction

Concentration

Diversification

Vertical Integration

Divestiture

Liquidation

Growth Strategy-Concentration
A

concentrated growth strategy involves focusing on increasing market share in existing markets. This strategy is also sometimes called a concentration or market dominance strategy. In a stable environment where demand is growing, concentrated growth is a low risk strategy. Concentration may involve increasing the rate of use of a product by current customers; attracting competitor's customers; and/or attracting nonusers/ new customers. Eg: Microsoft in Computer software and related products, Asian Paints in paints.etc.

Growth Strategy- Vertical Integration

Vertical integration is a strategy used by a company to

gain control over its suppliers or distributors in order to increase the firms power in the marketplace, reduce transaction costs and secure supplies or distribution channels Vertical integration may be of two typesbackward and forward. (i) Backward Integration: It involves moving toward the input of the present product. It is aimed at moving lower on the production process so that the firm is able to supply its own raw materials or basic components. Eg: Reliance Industries Ltd. Has been able to grow largely through backward integration. It started business with textiles and went for backward integration to produce PFY and PSF critical raw materials for textiles, PTA and MEG raw materials for PFY and PSF, propylene raw materials for PTA and MEG, and finally naphtha for producing propylene.

Growth Strategy- Vertical Integration

(ii) Forward Integration: It means the firm

entering into the business of distributing or selling its present products. It refers to moving upwards in the production/distribution process towards the ultimate consumer. The firm sets up its own retail outlets for the sale of its own products. For example, many companies like Bata, DCM, Bombay Dyeing, Raymonds and Reliance have set up their own retail outlets to sell their fabrics.

Growth Strategy-Diversification
Beyond a certain point, it is no longer possible for

a firm to expand in the basic product market. So the firm seeks increased sales by developing new products for new markets. This strategy towards growth is called diversification. The diversification does not simply involve adding variety in a product but adding entirely different types of products. Products added may be complementary.

Diversification- A) Concentric
When a firm diversifies into some business which

is related with its present business in terms of marketing, technology, or both, it is called concentric diversification. For example, Mother dairy has added 'curd and Lassi to its range of milk products.

Diversification- B) Conglomerate
When a firm diversifies into business which is not

related to its existing business both in terms of marketing and technology it is called conglomerate diversification. Several Indian companies have adopted this strategy. Reliance, Sahara, DCM, Essar group, ITC, Godrej are examples of conglomerate diversification.

Stability Strategy
Stability strategy implies continuing the current

activities of the firm without any significant change in direction. If the environment is unstable and the firm is doing well, then it may believe that it is better to make no changes. A firm is said to be following a stability strategy if it is satisfied with the same consumer groups and maintaining the same market share, satisfied with incremental improvements of functional performance and the management does not want to take any risks that might be associated with expansion or growth.

Contraction Strategy
Contraction is opposite of growth. It may be effected

through divestiture or liquidation. Divestiture involves sale of a business unit or plant of one firm to another. Eg: When Coromandal Fertilizers Ltd. Sold it cement division to India cements Ltd. In law, liquidation is the process by which a company (or part of a company) is brought to an end, and the assets and property of the company redistributed. Liquidation is also sometimes referred to as windingup or dissolution, although dissolution technically refers to the last stage of liquidation

Aspects Relating to Conglomerate Diversification

Conglomerate

diversification occurs when a company stretches out its business into an area which is dissimilar to its core business. This often occurs due to a merger or buyout of another company, or it can occur if the company simply wants to develop different products that aren't related to the ones they already produce.

History of conglomerate
In 1960s, conglomerates were popular as the very concept

of a corporate structure was the symbol of the power. This allowed these conglomerates to buy other businesses at leveraged rates. In that time, the only method to measure the real value of a company was its return on investment (ROI). Due to this, if the target company had the profits for a period larger than its interest paid on the loans, it was considered to grow. Due to their impact, conglomerate also had an improved aptitude in borrowing than a smaller firm in money market and capital market. This allowed the conglomerates to raise their stock value for many years as these were considered the giants in the business. Many investors considered it secure to invest in these corporate structures. Since the stock permitted them to raise money, these conglomerates could take out loans

Conglomerate Diversification- Advantages & Disadvantages

Advantages Risk spreading : entering new

Disadvantages
Management costs increases

products into new markets offers protection against failure of current products and markets. High profit opportunities :Ability to move into high growth profitable industries especially important if current industry is in decline. Escape : from the present business if competition is too hot. Better access to capital markets.

due to size of the group Conglomerates have to face many accounting-related problems, for example, consolidation and group disclosures, etc. Taxation of group structure reduces the taxation benefits Failure in one business will drag down the rest. Lack of management experience Focus is lost, and it is difficult to manage unrelated and welldiversified business effectively Due to multinational business, conglomerates often contact cultural difference due to which values are destroyed

Investing in non-core businesses: Has diversification worked for India Inc?

ITC Cigarettes

to hotels conglomerate, ITC, is one of those rare examples where the company has successfully diversified much beyond its core business. The company, which started as a tobacco products manufacturer, eventually expanded to hotels, paper and packaging, with agri-business and foods being added

Unitech
Delhi-based Unitech

made a foray into the malls and entertainment business about a decade ago, chalking out Rs 1,500 crore to set up amusement parks and entertainment centres. Then, in 2007, buoyed by a strong cash flow, it expanded into telecom. This would add value to the group, the company claimed, while real estate remained its mainstay.

Videocon Industries
This 'Indian multinational'

started out primarily as a consumer durables manufacturer, but its ambitions have today led it into a wide-ranging set of businesses, which include oil exploration, telecommunications, financial services, direct-to-home, apart from its staple consumer durables division. Of these businesses, the oil & gas foray has proved quite successful for Videocon, and is likely to become a moneyspinner in the coming years. The company owns a stake in oil fields in Brazil, Indonesia and Mozambique

UB Holdings
Much of liquor baron Vijay

Mallya's current problems have manifested from his overzealous diversification drive, which has affected even his core businesses. Along with United Spirits and United Breweries, the group had in place a solid foundation with strong, stable cash flows and growing profitability. However, the ambitious Mallya wanted to take the firm on another trajectory, and hence the expansion in fertilisers, aviation, engineering and real estate.

Portfolio Planning Tools

In a multi-business firm, allocation of resources

across various business is 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 Electrics Stoplight matrix and the McKinsey matrix

BCG Matrix

 The Boston Consulting Group (BCG) matrix helps

companies evaluate each of its strategic business units based on two factors: (1) the SBUs market growth rate (i.e., how fast the unit is growing compared to the industry in which it competes) and (2) the SBUs relative market share (i.e., how the units share of the market compares to the market share of its competitors). Because the BCG matrix assumes that profitability and market share are highly related, it is a useful approach for making business and investment decisions. Stars : Everyone wants to be a star. A star is a product with high growth and a high market share. To maintain the growth of their star products, a company may have to invest money to improve them and how they are distributed as well as promote them. The iPod, when it was first released, was an example of a star product. Cash Cows: A cash cow is a product with low growth and a high market share. Cash cows have a large share of a shrinking market. Although they generate a lot of cash, they do not have a long-term future. For example, DVD players are a cash cow for Sony. Eventually, DVDs are likely to be replaced by digital downloads, just like MP3s replaced CDs.

 Questions Marks or Problem Children: Question

or problem arises when a product has a low share of a high-growth market. Managers classify these products as question marks or problem children. They must decide whether to invest in them and hope they become stars or gradually eliminate or sell them. For example, as the price of gasoline soared in 2008, many consumers purchased motorcycles and mopeds, which get better gas mileage. Dogs: In business, it is not good to be considered a dog. A dog is a product with low growth and low market share. Dogs do not make much money and do not have a promising future. Companies often get rid of dogs. However, some companies are hesitant to classify any of their products as dogs. As a result, they keep producing products and services they shouldnt or invest in dogs in hopes theyll succeed.

General Electrics Stoplight Matrix

The General Electric Company is highly admired

for the sophistication, maturity and quality of its planning system .It uses a 3x3 matrix called General Electrics Stoplight Matrix to guide the allocation of resources. The matrix calls for evaluating the businesses of a firm in terms of two key issues: Business Strength: How strong is the firm vis-a vis its competitors? Industry attractiveness: What is the attractiveness or potential of the industry?

General Electrics Stoplight Matrix

In d u st ry A tt r a ct iv e n e s s H i g h
M e di u m

Stron g Invest

Averag e Invest

Weak Hold

Invest

Hold

Divest

L o w

Hold

Divest

Divest

Business Strength

General Electrics Stoplight Matrix

Business which are favorably placed justify

substantial commitment of funds. Business which are unfavorably placed call for divestment. Businesses which are placed in between qualify for modest investment.

McKinsey Matrix
The McKinsey matrix has 2 dimensions viz.,

competitive position and industry attractiveness. The criteria or factors used for judging competitive position and industry Industry Attractiveness Competitive Position for attractiveness along with suggested weights Criteria Criteria Weight them are: Weight
Industry Size Industry Growth Industry Profitability Capital intensity Technological stability Competitive intensity 0.10 0.30 0.20 0.05 0.10 0.20 Market Share Technological knowhow Product Quality After-sales service Price Competitiveness Low operating costs Productivity 0.15 0.25 0.15 0.20 0.05 0.10 0.10

McKinsey Matrix
Once an SBU is assessed on the dimensions of competitive position and industry attractiveness it is placed in one of the nine cells given in the 3x3 matrix.

Note: Winners- Larger commitment of resources Losers- Disinvestments Question Mark or Average Business or Profit Producers-Moderate commitment of resources High

Competitive Position Good Medium Poor

Winners

Winners

Question Mark

Industry Medium Attractiveness Low

Winners

Average Business

Losers

Profit Producers

Losers

Losers

Business Level Strategies

Senior executives and managers involved in the

development and implementation of businesslevel strategies are tasked with identifying the core competencies within the various functional departments of the company and combining them in a way that provides the company with the best opportunity for achieving and sustaining a competitive advantage in its chosen environment. Objective: The overall goal of business-level strategy is to protect the companys position in its current domain and, if possible, enlarge the domain in which the company can operate with a competitive advantage.

Steps for Creation of the Business-Level Strategy

Companies can create a core competency at the

functional level either by reducing the costs of performing the value-creation activities that occur within the function (low cost advantage) or performing the value-creation activities that occur within the function to differentiate its products from those offered by competitors in a way that customers perceive as having value (differentiation advantage). Step 1): Selecting the domain(s) in which the company will be competing for scarce resources (e.g., capital, personnel, technology, inputs and customers) . Step 2): Positioning the company in each chosen domain so that its function-based core competencies are most effectively leveraged to establish a competitive advantage.

Porters Generic Business Level Strategy

Business level strategies are popularly known as

generic or competitive strategies. Michael Porter classified these strategies into overall cost leadership, differentiation and focus. The first two strategies are broader in concept as their competitive scope is wide enough whereas the third strategy i.e. the focus strategy has a narrower competitive scope.

Porters Generic Business Level Strategy

Cost Leadership Business Strategy

When the competitive advantage of a firm lies in

a lower cost of products than the competitors product then it is called as cost leadership. This strategy gives importance on cost control and cost reduction technique. This strategy is used to gain market share. Eg:-Dell Computers in computers, Hero Motors in motorcycles, etc.

Cost Leadership Business StrategyConditions

Cost Leadership Business Strategy

Strategy of Cost Leadership: Dell Computer Corporation

Direct selling
Built-to-order manufacturing Low cost service Negative working capital

Differentiation Business Strategy

When the competitive advantage of a firm lies in

special features incorporated into the product, when specific products are demanded by the customers who are willing to pay for those, when customers need the special system of distribution then the strategy adopted is the differentiation business strategy. Differentiation can be achieved by keeping cost down and this savings can be reinvested in specific product features. Eg:-Rolex in Wrist Watches, Raymond in Textiles, Intel in microchips, etc.

Differentiation Business StrategyConditions

Differentiation is possible in terms of:

(a) product design,

(b) quality of product,

(c) technology, (d) distribution system, (e) customer service etc.

Focus Business Strategy

Focus business strategies essentially rely on either cost

leadership or differentiation but cater to a narrow segment of the total market. In terms of the market, therefore, focus strategies are function strategies. Under this strategy the firm enjoys advantage than the firms that do not offer product on segmented basis. (i) Cost Focus: Firm concentrates on a narrow line of products or limited market segment. Within this domain, it achieves cost leadership through sustained efforts. Eg: McDonalds pursues a strategy of cost focus by offering limited menus to achieve economies of scale. (ii) Differentiation Focus: Involves concentrating on a limited market segment wherein the firm can offer a differentiated product based on its innovative capabilities. Eg: Porsche specialises in sports car, a market segment in which it competes with the likes of GM and Nissan.

Condition under which focus strategies are used

i) There are specialized requirement for using the

products or services that the common customers cannot be expected to fulfill. ii) The market is big enough to be profitable for the focused firm. iii) There is a promising potential for growth in the market segment.

Strategic Planning and Capital Budgeting

Environmental Assessment

Managerial Vision, Values and Attitudes

Corporate Appraisal

Strategic Plan

Capital Budgeting

Product Strategy, Market Strategy, Production Strategy, and so on

Strategic Planning & Capital Budgeting

Strategic Planning: refers to the formulation of a unified, comprehensive and integrated plan to get the strategic advantages by challenging the environment

Strategic Position and Action Evaluation (SPACE)

The Strategic Position and Action Evaluation (SPACE)

Matrix is one of the strategic management tool for analyzing the company and its environment to formulating the strategies. It is four-quadrant structure which specify whether aggressive, defensive, competitive or conservative strategies are most suitable for a given organization, company or business. The SPACE Matrix axis signify the 2 external proportions which are industry strength (IS) and environmental stability (ES) and two internal dimensions of a competitive company which are competitive advantage (CA) and financial strength (FS).

Strategic Position and Action Evaluation (SPACE)

Strategic Position and Action Evaluation (SPACE)

Strategic Position and Action Evaluation (SPACE)

Steps to Developing a SPACE Matrix

1. 2.
i. ii.

Select a set of variables to define FS, CA, ES, & IS Assign a numerical value:
From +1 to +6 to each FS & IS dimension From -1 to -6 to each ES & CA dimension

3.
4. 5.

6.

Compute an average score for each FS, CA, ES, & IS Plot the average score on the appropriate axis Add the two scores on the x-axis and plot the point. Add the two scores on the y-axis and plot the point. Plot the intersection of the new xy point Draw a directional vector from the origin through the new intersection point.

SPACE Matrix
Conservative FS
+6 +5 +4 +3 +2 +1

Aggressive

CA
-6 -5 -4 -3 -2 -1 -1 -2 -3 -4 +1 +2 +3 +4 +5 +6

IS

Defensive

-5 -6

Competitive ES

SPACE