CHAPTER 2

STRATEGY AND CAPITAL

ALLOCATION
 OUTLINE

Concept of strategy
Grand strategy
Diversification debate
Portfolio strategy
Business level strategy
Strategic planning and capital budgeting
 Concept of Strategy

Chandler 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 the goals.

Strategy involves matching a firms strengths and weaknesses

with the opportunities and threats present in the external
environment.
 Formulation of Strategies
Environmental Analysis Internal Analysis

Customers Technical know-how

Competitors Manufacturing capacity
Suppliers Marketing and
Regulation distribution capability
Infrastructure Logistics
Social/political Financial resources
environment

Opportunities and threats Strengths and weaknesses

Identify opportunities Determine core capabilities

Find the fit between

core capabilities and
external opportunities

Firms strategies
 The Thrust of Grand Strategy

Grand
Strategy

Growth Stability Contraction

Concentration Vertical Liquidation Divestiture

integration

Diversification
 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
 Diversification Debate
Pros and Cons
Reduces overall risk exposure
Expands opportunities for growth
Dampens profitability

Diversification and Risk Reduction

ROI
A
(A+B)

B
 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 Failure Form of Source of Value

Diversification Addition

Capital markets Unrelated Governance

diversification economies
Product markets Vertical integration Coordination
economies
Resource markets Related diversification Scope economies
Risk markets Strategic Option economies
diversification
 Diversification A Mixed Bag

Positives Negatives

Managerial economies of Dissipation of managerial

scale focus
Higher debt capacity Unprofitable investment.

Lower tax burden

Larger internal capital

 Compulsions for Conglomerate Diversification in India

Restriction in growth in the existing line of business, often arising from governmental
refusal to expansion proposals.
Vulnerability to changes in governmental policies with respect to imports, duties,
pricing, and reservations.
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
from year to year.
Bandwagon mentality which has been induced by years of close regulation of
industrial activity.
Desire to avail of tax incentives mainly in the form of investment allowance and large
initial depreciation write-offs.
A self-image of venturesomeness and versatility prodding companies to prove
themselves in newer fields.
A need to widen future options by entering newly emerging industries where the
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
current market?
What strategic assets do we need in order to succeed in the new
market?
Can we catch up to or leapfrog competitors at their own game?
Will diversification break up strategic assets that need to be kept
together?
Will we simply be a player in the new market or will we emerge a
winner?
What can our company learn by diversifying and are we sufficiently
organised to learn it?
 Guidelines for Conglomerate Diversification
1. If you lack financial sinews to sustain the new project during the learning
period, avoid grandiose diversification projects.
2. Realistically examine whether you have 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 a very early entrant in the field you are diversifying into.
This will protect you from serious competitive threat in the initial years.
5. Where possible adopt the following sequence: marketing substantial sub-
contracting full blown manufacturing.
6. Seek partnership of other firms in areas where you are vulnerable or competitively
weak.
7. If the failure of the new project can threaten the companys existence, float a
separate company to handle the new project.
8. Remember that meaningful conglomerate diversification represents the greatest
challenge to corporate vision and leadership.
9. 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 Electrics
stoplight matrix, and the Mckinsey matrix.
 BCG Matrix
Market Share
High Low

High
Question
Stars Marks
G

R
k

h
o

a
e

e
t

t
Low

Cash Dogs
Cows
 Pattern of Capital Allocation

Part A

Stars Question marks

Cash cows Dogs on divestment

(funds generated) (funds released)
Part B

Stars Question marks

1

Cash cows Dogs

 General Electrics Stoplight Matrix
Business Strength
A Strong Average Weak
t
t
H

Invest Invest
g
I h Hold
i

r
n
a
d
c
u
t Hold Divest
s Invest
i
M

m
d

u
e

t
v
r
e
y
n
e Hold Divest Divest
w
L
o

s
s
 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 0.40
Industry growth 0.30 4 1.20
Industry profitability 0.20 3 0.60
Capital intensity 0.05 2 0.10
Technological stability 0.10 2 0.10
Competitive intensity 0.20 3 0.60
Cyclicality 0.05 2 0.10
3.10
Competitive Position
Key Success Factors Weight Rating Weight Score
Market share 0.15 4 0.60
Technological know how 0.25 5 1.25
Product quality 0.15 4 0.60
After-sales service 0.20 3 0.60
Price competitiveness 0.05 4 0.20
Low operating costs 0.10 4 0.40
Productivity 0.10 5 0.50
4.15
 The McKinsey Matrix

Competitive Position
A
Good Medium Poor
t
t
I r High Winner Winner Question Mark
n a
d c
u t
s i Medium Winner Average Business Loser
t v
r e
y n Low Profit Producer Loser Loser
e
s
s
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 It acts proactively to shape an emerging industry to its advantage.

Deal Maker It spots and executes deals based on its superior insights.
Scarce Asset Allocator It allocates capital and other resources efficiently across different
businesses.

Skill Replicator It facilitates the lateral transfer of distinctive resources.

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

Talent Agency It attracts, retains, and develops talent.

Growth Asset Allocator It leads innovation in multiple businesses.

* 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
 Portfolio Configuration

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.

According to C.K. Prahalad and Yves Doz there are different

ways of thinking about relatedness:
Business selection
Parenting similarities
Core competencies
Interbusiness linkages
Complex strategic integration
 Barriers to Effective Corporate
Portfolio Management - 1

Corporate portfolio management perhaps has the greatest impact on

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

Three major barriers to effective corporate portfolio management

are:
Measurement and information problems
Behavioural factors
Corporate governance and incentives
 Barriers to Effective Corporate Portfolio Management - 2
Measurement and information problems
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 on.

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

Behavioural Factors
Sunk cost thinking
Loss aversion
Endowment effect
Status quo bias
Corporate governance and incentives
Despite understanding the logic of shareholder wealth maximisation, many
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 firms dont compete at the corporate level. Rather, a

business unit of one firm competes with a business unit of another.
Among the various models that have been used as frameworks for
developing a business level strategy, the Porters generic model is
perhaps the most popular

According to Porter, there are three generic strategies that can be

adopted at the business unit level.

Cost leadership
Differentiation
Focus
 Strategy of Cost Leadership:
Dell Computer Corporation

Direct selling
Built-to-order manufacturing
Low cost service
Negative working capital
 Porters Generic Competitive Strategies

Sources of Competitive Advantage:

Unique Value as Lowest Cost

Perceived by
Customer

Broad
(industry-wide) Overall Overall Cost
Strategic Scope Differentiation Leadership

Narrow
(segment only) Focused Focused Cost
Differentiation Leadership
 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.
 Strategic Planning and Capital Budgeting

Environmental Managerial vision, Corporate

assessment values, and attitudes appraisal

Strategic plan

Capital Product strategy,

budgeting market strategy,
production strategy,
and so on
 Generic Strategies and Key Options

Status Quo FS Concentric Diversification

Conglomerate
Concentration
Diversification

FOCUS COST
Vertical
LEADERSHIP
Integration
Diversification Conservative Aggressive

CA IS
Divestment Defensive Competitive
Concentric
Merger
GAMESMAN- DIFFEREN-
Liquidation
SHIP TIATION Conglomerate Merger

Retrenchment Turnaround
ES
 SUMMARY
Capital budgeting is not the exclusive domain of financial analysts and
accountants. Rather, it is a multifunctional task linked to a firms overall strategy.
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
analysed and evaluated in detail to determine their worthwhileness.
Strategy involves matching a firms strengths and weaknesses its distinctive
competencies with the opportunities and threats present in the external
environment.
The thrust of the overall strategy or grand strategy of the firm may be on growth,
stability, or contraction.
Generally, companies strive for growth in revenues, assets, and profits. The
important growth strategies are concentration, vertical integration, and
diversification.
While growth strategies are most commonly pursued, occasionally firms may
pursue a stability strategy.
 Contraction is the opposite of growth. It may be effected through divestiture or
liquidation.

Conglomerate diversification, or diversification into unrelated areas, is a very

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

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
and focus. Many conglomerates created in the 1960s and 1970s have been
dismantled and restructured. Tarun Khanna and Krishna Palepu, however, believe
that while focus makes eminent sense in the west, conglomerates may have certain
advantages in emerging markets which are characterised by many institutional
shortcomings.

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 Electrics stoplight matrix , and the Mckinsey matrix.
 Diversified firms dont compete at the corporate level. Rather, a business unit of
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 Porters
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
leadership, differentiation, and focus.

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