Chapter 12 Evaluating strategies Key terms acceptability 382 balanced scorecard 373 Du Pont model 372 evaluation 394 feasibility 392 gap analysis 375 returns 382 risk 388 SAFE 376 suitability 376 triple bottom line 374 Learning outcomes After reading this chapter you should be able to: + Assess the performance outcomes of different strategies in terms of direct economic outcomes and overall organisational effectiveness. + Assess performance using different techniques, + Identify the need for new strategies using gap analysis: + Employ SAFE (Suitability, Acceptability, Feasibility and Evaluation) to identify optimal strategic options. * Use a range of different techniques for evaluating strategic options on both financial and non-financial grounds. m1 Strategy inaction Leading & hanging121 Introduction 12.1 Introduction In 2018, Chief Executive Heinrich Hiesinger of Thyssenkrupp, the product of merging two large German steel companies, resigned, He had presided over the company’s ext from steel bbut the company’s share price had fallen 28 per cent since he took office in January 2011 Investors pushed forthe break-up ofthe company that now encompassed submarines eleva- tors and car parts, as they felt it suffered from a conglomerate discaunt. Newly appointed ‘CEO Guido Kerkhoffis now planning to split the company and is fring managers who stand in his way, Hs strategy needs to address two key questions: what level of performance must bbe achieved, and what criteria should he use to evaluate his options? This chapter is about assessing current organisational performance and evaluating diferent strategic options, I follows the focus in Pat Il on various strategie cholces such as differentiation, diversification, internationalisation, innovation and acquisitions. Now itis time to consider how to judge these strategies, MARaGeTsIaveNterassessThOWWel ‘theiexisungistraxegiesTareyperfonming(andrevaluateraltermatves| This chapter focuses fon the use of systematic criteria and techniques for objective analysis - a rational ‘Design’ perspective (see the Strategy Lenses in the Commentary o Part 1). Chapter 13 considers ‘the role of such formal methods within the complex processes of strategy development as awhole In this chapter we consider a range of organisational performance measures, both economic measures and broader measures of organisational effectiveness. We address the question of performance comparators: in other words, what should an organisation's performance be compared to, We also introduce gap analysis a a tool for assessing depar. tures from desired levels of performance. Gap analysis can be used as well to identify the scale ofthe strategic initiatives needed in order to close the gap between actual and desired levels of performance. The chapter goes on to propose four criteria for systematically evalu- ating possible strategic initiatives, summarised by the acronym SAFE: Suitability, Accept- ability, Feasibility, Evaluation, Suitability assesses whether a strategy addresses key strategic challenges an organisation faces, Acceptability determines whether a strategy meets stake- holder expectations, Feasibility examines its practicality and Evaluation synthesses these assessments for the most optimal strategy, asthe results for each often suggest different strategies to take forwards Figure 121 organises the key elements of this chapter. Here managers ist assess perform ance; next they identity the extent of any gap between desired and actual or projected performance; finaly they assess the strategic options for filling any such gap. The adopted ‘options themselves eventually feed back into performance in the future. Figure 12.1. Evaluating strategies ‘assess options + Suitability + Acceptability + Feasibility + EvaluationChapter 12 Fvaluating strategies 12.2 Organisational performance an There are many techniques for measuring organisational performance, with diverse organ- isations preferring different measures. However they broadly fall into two categories of ‘economic and effectiveness measures, with economic ones being far more widely used Economic measures suffer from limitations that are discussed below and which the broader effectiveness measures attempt to address. This section therefore introduces both direct ‘economic and effectiveness measures and goes on to consider various compatisons against which performance may be assessed, It finally discusses gap analysis, 12.2.1 Performance measures We can distinguish between two basic approaches to performance:direct economic perform ance and overall organisational effectiveness." + Economic performance refers to direct measures of success in terms of economic outcomes, ‘These economic outcomes have three main dimensions: * Performance in product markets: for example, sales growth or market share, or for not for-profits this might be growth in membership or money raised for charities. Vari- ations in these figures may be seen as alead indicator of a company’s competitiveness inits market. + Accounting measures of profitability, such as profit margin or return on capital employed (ROCE). A useful technique for unpacking the drivers of company profit: ability s the Du Pont model (see Figure 12.2), which dissects a company's return on capital employed (ROCE) in order to work out the components that add value to, or subtract from the whole. Itis particularly powerful in tracking changes over time and in comparison with competitor ratios. For instance, looking at selling, general and administrative expenses in Figure 12.2; f these are increasing over time, and partieu- larly if these seem high in relation to competitors'figures, then the profitability of the business would be improved if attention was paid to reducing these sorts of adminis trative costs (see also Section 12.4.2 below). * Financial market measures such as movements in share price. Companies watch thelr share price carefully as it sa key indicator of market sentiment of the expected future success of an organisation, As in the opening example of Thyssenkrupp, the precipitate {allin its share price showed the market’ ack of confidence in the company's strategy and its CEO Heinrich Hiesinger. ‘These economic measures may seem objective, but they can be conflicting and need carefulinterpretation. Sales growth, for example, may be achieved by cutting prices, thereby reducing profit margins. For Thysseenkrupp, although in 2018 sales were increasing from €30.8bn to €21.7bn, net results and share price were down significantly. This means that different performance measures may pointin different directions and so economic perform. ance’is best evaluated by more than one measure, Itis also why many organisations are now looking to more comprehensive measures of effectiveness as well + Effectiveness refers to a broader set of performance criteria than just economic, for example measures reflecting internal operational efficiency or measures relevant to stake- holders such as employees and external communities. One important broad technique far assessing effectiveness is the balanced scorecard,12.2 Organisational performance igure 12.2 The DuPont model Disaggregating return on capital employed Source 1. Keller ea, Valuation, 5c, Chichester, ohn Vile & Sons ted 2010 + The balanced scorecard considers four perspectives on performance simultaneously in order to prevent the dominance of a single perspective? Thus it considers the i finan. ‘dal perspective, which for a for-profit company typically means focusing upon increasing shareholder value, This can be achieved through revenue growth and productivity gains, such as cost reduction and efficiency gains. Typical measures include profitability or share- price performance; i) customer perspective, as this defines how a company diferenti- ates itself from competitors in the market. This can be assessed using measures such as ‘customer satisfaction or product quality, ii) internal business perspective, focuses upon, alignment between organisational processes and financial and customer perspectives. Here productivity measures or project management measures are often used. Often poor alignment between the internal perspective and the financial and customer perspectives, leads to poor outcomes as a company intending to compete on innovation and value- added customer relationships is unlikely to do well f internal focus is upon cost reduc ‘tion; and finally tev) innovation and learning perspective, which assesses the employee ‘capabilities and skills and corporate climate needed to support strategy Typical measures, include new product introductions or employee skill so that human resources and infor: mation technology align with the other perspectives. The performance measures of each perspective can be cascaded down through the organisation to individual business units ‘o allow overall alignment. This can be visualised using a strategy map,* which isa logical and comprehensive architecture that specifies critical elements and their links to an organ- Isation’s strategy. By integrating overall financial goals with strategic and operational targets, the balance score card ensures that the pursuit of short-run financial goals snot at the expense of the longer-term strategic positioning of the company. aChapter 12 Fvaluating strategies a4 + Another similarly broad measure of performance i the tiple bottom line, which pays explicit attention to corporate social responsibilty and the environment. Thus the tiple bottom ine has three dimensions: economic measures of performance such assales, profits and share price: social measures, uch 3 employee training, health and safety and contibu- ‘ons tothe local community; ang finally environmental measures such as pollution, reoy- dling and wastage targets. Most listed companies today publish sustainability reports and Dutch brewer Heineken¢ is good example, showing the company’s standing on the Dow Jones sustainability index and lists speci social metrics for employees (reducing accident frequency. training, employee volunteering) and environmental metrics (water usage, CO2 ‘emissions and energy x 1210 cratbeers {{=favourabie x=unfayourble ?=uncertan Asmestfaourable B=pessible Caunsutable Sources: Busnes Inside, 17 September 2015; Bloomberg, 16 September 2015; New York Times, 8 October 2015; wrwdageo.com ‘wontheheinekencompany.com/aboutusicompany strategy, Wal Street oural 28 September 2015, Questions 1 Are there other strategic options or factors Heineken should consider? 2 How could you improve the ranking arabs? 3 Consider the most favoured option in terms of acceptabity and easy eriteria. requirements that must be met (such as growth, investment or diversity). llustration 12.3, provides an example. The end point of the decision tree isa number of development oppor- tunities. The elimination process is achieved by identifying a few key elements or criteria that possible strategies need to achieve. In Illustration 12.3 these are perceptions of market demand, level of new competitor threat and intended resource commitment. As the illus- tration shows, anticipating a sustained fall in market demand suggests that future strategy should rank options 1-4 more highly than options 5-8. At the second step, the higher perceived threat of new competitors would rank options 1 and 2 above 3 and 4, but a lack Cf willingness to commit significant resources to the new strategy would suggest an inter- national alliance may be the best way forward. The danger here is that the choice at each branch on the tree can tend to be simplistic. For example, as the illustration points out, answering ‘yes’ or ho’ to resource commitment does not allow for the wide variety of options that might exist within this strategy, 381Chapter 12 Fvaluating strategies Ilustration 12.3 How to decide among strategy options at a family business — a decision tree analysis {At the beginning of the book, a case was described where Clausia, a junior consultant was tasked with coming up with some options for the CEO of a medium-sized family business ‘The business was facing new aggressive compstition in is main European markets and faling demand fr its products The CEO was wondering whether now was the right time to aggressively build market share or make an acquisition in 9 ew international market ‘or growth, orto invest further in ‘newproduct innovation, Claudia knew the firmwas nancaly| soundwitha strong balance sheet, but profits were beginning ‘to decline and thelevelof appetite fr significant investment ‘wasn't clear. The CEO seemed enthusiastic at the prospect of expansion into new international markets and had even ‘mentioned that she would be receptive tothe idea of making an acquisition ifthe right opportunity presented tel. In order to help the decision process Claudia identified some key criteria that would be used to help identity appro: priate strategic options, cluding current market growth rate, the level of threat posed by new competitors and how much resources the fm would committe a new strategy. Using a decision tree approach (se adjoining page, Claudla ‘was able to determine the best strategic options based on ‘the key criteria, Alo it might help remove certain options currertiybeing discussed shat would not fitthose cteriaand might even give rise to other alternatives that had previously rot been mentioned. The analyss indicates that ifthe CEO perceives the core market to be in decline due o falling sales and attack from competitors, then inorganic expansion overseas might be preferred strategic options (1-4) over options 1-5. As a further step, if the business was prepared to commit signif leant resources to the expansion, then international acqui sition might be the preferred option. If perceptions of the threat of market downturn and competitor entrance are lower, then more organic options might be preferred anda more defensive marketing strategy pursued, Despite the clarity of choice that the decision tree presents about which strategic option would be the most appropriate for the client, Claudia was concerned that the choices were perhaps a litle too simplisti and dian alow for arange of answers She also wortied that further canver- sations with the CEO might yield other important criteria ‘that were not included in the analysis Questions 1 Try reversing the sequence of the key criteria, redraw the tree and see if this resuk ina cifferent set of str tegic outcomes? 2. Clauala subsequently found out that the CEO was also wondering about whether to expand within the same business area orto diversify into a new one. Redraw the tree with this new fourth criteria and see what 19 strategic options you generate. 12.4 Acceptability ae Acceptability is concerned with whether the expected performance outcomes of a proposed strategy meet the expectations of stakeholders. These can be of three types, the’3 Rs": Return, Risk and stakeholder Reactions. It's sensible to use more than one approach in assessing the acceptability ofa strategy. 12.4.1 Return The first & is returns. These are measures of the financial profitability and effectiveness of a strategy. In the private sector, investors and shareholders expect a financial return on their investment, In the public sector, funders typically government departments) are likely ‘to measure returns in terms of the ‘value for money’ of services delivered, Attention often focuses on financial metrics of efficiency but measuring return for not-for-profits is notori- ously difficult as there is great diversity in the sector in terms of multiple, often conflicting,12.4 Acceptability Decision tree to evaluate future strategic options stakeholder interests, Nevertheless three types of performance metric can be used that include success in mobilising resources, staff effectiveness and progress in fulfilling mission, The exact specification of these metrics will vary by not-for-profit organisation.” Measures of return are a common way of assessing proposed new ventures or major pro- jects within businesses, An assessment of the financial effectiveness of any specific strategy should be a key criterion of acceptability ancial analysis? There are four common approaches to financial return (see Figure 12.4): Return on capital employed (ROCE) calculates profitability in relation to capital for a specific time period after a new strategy is in place (see Figure 12.2 for ROCE drivers) For the example in Figure 12.4(a) a ROCE of 10 per centis anticipated by year 3. The ROCE (typic- ally profit before interest and tax ~ PIT - divided by capial employed) is a measure of the ‘earning power of the capital resources used in implementing a particular strategic option (see Section 12.5.1 below). Its weakness s that t does not focus on cash flow or the timing of cash flows (see the explanation of DCF below). A similar measure is return on invested capital 382‘Chapter 12 Evaluating srategies aes Figure 12.4 Assessing profitability 1s Roce 10 %) ° ° 1 2 3 Time years) {a) Return on capital employed 15 Payback potiod = 3.5 years 10 Net 5 cash flow (emo “10 (b) Payback period 1s 1, Total cashflow of venture = €16m aria eiscourten each low = €8. 78 et present value) xe @ 4514.13) 8168) 4616.0) 5 (3.1) tow 2 3211.82) $20.1) fem Tine yeaa af + Using a discounting rate of 10%. {6) Discounted cash tow OCF) Figures in brackets ae eiscounted by 10% annually. (ROIC), famously used by Michael Porte (2008) as a method to determine the extent of a ‘company'scompetitive advantage. Ithas the attraction, as sed by Porter, to enable compar ison across companies in a particular industry to assess relative performance. Expressed as a formula itis ROIC= Net operating profits after tax/total invested capital For other measures of return see endnote 13." + The payback period assesses the length of time it takes before the cumulative cash flows fora strategic option become positive. Inthe example in Figure 12.4(b) the payback period Is three and a half years. This measure has the virtue of simplicity and is most often used where the dificuly of forecasting is high and therefore risk is high. In such circumstances ‘this measure can be used to select projects or strategies that have the quickest payback. ‘Thus acceptable payback periods vary from industry to industry. A venture capitalist investing in a high-technology startup may expect a fast return, whereas public infra- structure projects such as road building may be assessed over payback periods exceeding12.4 Acceptability 50 years, One problem with the basic payback period method is that it assumes that fore: ‘east cash flows are equally valuable in the future, however risky or distant: €100 predicted in three years’ time is given the same weight as €100 next year. Organisations therefore often use ‘discount’ methods to allow for greater uncertainty in the more distant future, + Discounted cash flow (DCF is a widely used investment appraisal technique using common cash-flow forecasting techniques which ‘discounts’ (gives less value to) earnings the further into the future they are. The resulting measure isthe net present value (or NPV) af the project, ‘one of the most widely used criteria for assessing the financial viability ofa project.In principle, ‘given limited resources, the project wth the best NPV should be selected. However, a DCF is only as valid as the assumptions built into it, soit is important to test sensitivity to different evalu- ations and scenatios, Taking the example of DCF in 12.4(c),once the cash inflows and outflows have been assessed for each of the years of a strategic option they are discounted by an appro: priate cost of capital. This cost of capitals the ‘hurdle’ that projects must exceed, The discount rate reflects the fact that cash generated earlyis more valuable than cash generated later, The discount rate is also set ata level that reflects the riskiness ofthe strategy under consideration, (ie a higher rate for greater risk). Inthe example, the cost of capital or discounting rate of 10 per cent (after tax) reflects the rate of return required by those providing finance for the venture shareholders and/or lenders. The 10 per cent cost of capital shown here includes an allowance for inflation of about 3-4 per cent. Its referred to as the ‘money cost of capital By contrast, the rea” cost of capitals 6-7 per cent after allowing for or excluding inflation, The projected after-tax cash flow of £2m (€2.2m; $3m) atthe start of year 2is equivalent to receiving £1.82m now~£2m multiplied by 0,91 or 1/1,10, £1.82m scaled the present value lof receiving £2m at the start of year 2 ata cost of capital of 10 percent. Similatly, the after-tax ‘cash flow of £5m atthe start of year 3 has a present value of £4.13m—£5m multiplied by /1.10 squared, The net present value (NPV) of the venture, as a whole, is calculated by adding up all the annual present values over the venture’s anticipated fe. In the example, thisisseven years. The NPV works out at £8.78m. Allowing forthe time value of money, the £8.78m isthe extra value that the strategic initiative will generate during its entire lifetime, However, t would be sensible to undertake a sensitivity analysis, for example by assuming different levels of sales volume increases or different cost of capital in orderto establish what resulting NPV measures \would be and at what point NPV fallsbelow zero, For example, in Figure 12.3(¢)acost of capital ‘or discounting rate of about 32 per cent would produce azero NPV. Such sensitivity testing is, then, away in which DCF can be used to assess risk + Shareholder value analysis (SVA) is a variation on DCF analysis in that it values the whole business rather than specific projects. It focuses on the creation of value for shareholders as measured by share price performance and flow of funds. The approach relies upon identifying the key ‘value drivers’ for value creation in the business such as sales growth, profit margin improvement, capital investment decisions, capital structure decisions, cost of ‘capital, and their effect on future cash flow. Itis calculated by dividing the estimated total net value of a company based on its present and future cash flows, by the value of is shares \With regard to these four approaches to assessing returns, its important to remember that there are no absolute standards as to what constitutes @ good or poor return. It will differ between industries and countries and between different stakeholders, so that a higher return rather than a lower return, might be better for shareholders while for other stakeholders such as ‘employees, higher salaries might be preferred. So itisimportant to establish what return is seen, as acceptable by which stakeholders. There ae also three further problems of financial analysis + The problem of uncertainty. Be wary of the apparent thoroughness of the various approaches to financial analysis. Most were developed for the purposes of investment appraisal. Therefore, they focus on discrete projects where the additional cash inflows and ‘outflows can be predicted with relative certainty: for example, a retailer opening anew 385Chapter 12 Fvaluating strategies 386 store has a good idea about lkely turnover based on previous experience of similar stores in similar areas. Such assumptions are not necessatily valid in many strategic contexts because the outcomes are much less certain. It is as stategy implementation proceeds (with the associated cash-flow consequences) that outcomes become clearer (see the discussion of ‘eal options’ below). + The problem of specificity. Financial appraisals tend to focus on direct tangible costs and benefits rather than the strategy more broadly. However, its often not easy to identify, such costs and benefits, or the cash flows specific ta a proposed strategy, since it may not be possible to isolate them from other ongoing business activities. Moreover such costs and benefits may have spillover effects. For example, a new product may look unprofitable asa single project, But it may make strategic sense by enhancing the market acceptability of other products in a company's portfolio + Assumptions. Financial analysis is only as good as the assumptions built into the analysis. I assumptions about sales levels or costs ate misguided, for example, then the value of ‘the analysis is reduced, even misleading, This is one reason why sensitivity testing based Cn variations of assumptions is important. Real options'* Many of the previous approaches value strategic initiatives on a stand-alone basis. There are, however situations where the strategic benefits and opportunities only become clear as imple- mentation proceeds. For example, a diversification strategy may develop in several steps:it may ‘ake many years for the success of the initial diversification move to become clear and for possible follow-up opportunities to emerge. In these circumstances the traditional CF approach discussed above will tend to undervalue an initial strategic move because it does not take into account the value of options that could be opened up by the initiative going forward.'® In pharmaceuticals, for example, many research projects fal to produce new drugs with the intended benefit There ould, however, be other outcomes of value to a failed project:the research could create valuable new knowledge oF provide a ‘platform’ from which other products or process improvements spring. So a strategy shauld be seen asa series of ‘real’ options. A ‘real option" isthe right, but not the obligation, to undertake certain business initiatives, For instance it might include an ‘opportunity at a specific time to inves, expand or defer a capital Investment project. illustra ‘tion 124 provides an example. A real options approach to evaluation therefore typicallyincreases the expected value of a project because it adds the expected value of possible future options created by that project going forward, There are four main benefits of this approach: * Bringing strategic and financial evaluation closer together. Arguably it provides a clearer Understanding of both strategic and financial return and risk ofa strategy by examining each step (option) separately. + Valuing emerging options. In taking such an approach, it allows a value to be placed on new options made available by the initial strategic decision. The value of the first step is .ased by the opportunities that it opens up. + Coping with uncertainty. Advocates of a real options approach argue it provides an alter native to profitability analyses that requires managers to make assumptions about future: conditions that may well not be realistic. As such, it can be linked into ways of analysing Uncertain futures such as scenario analysis (Section 2.4). Applying areal options approach encourages managers to defer reversible decisions as ar as possible because the passage of time will clarify expected returns ~ even to the extent that apparently unfavourable strategies might prove viable at a later date. + offsetting conservatism. One problem with financial analyses such as DCFisthat high hurdle or discount rates set to reflect risk and uncertainty mean that ambitious but uncertain12.4 Acceptability Illustration 12.4 Real options evaluation for developing premium beers in India Areal options approach can be used to evaluate proposed projects with multiple options. ‘Abrewer of premium beershad been exporting its products to India for many years. They were considering an invest ment in brewing capacity in India Although it was envis ‘aged that, initially, this would take the form of brewing standard products locally and distributing through existing distributors, there were other ideas being discussed, though ‘these were all contingent on the building of the brewery. Management:ooka realoptions approach to evaluating the projectas set out inthe figure below. ‘The evaluation of the proposal to build the brewery ‘considered three options; to invest now, at a later date, ‘or not invest at all, However, the builaing of the brewery ‘opened other options. One of these was to cease oper: ating through existing third party distributors ane open up their own distribution network. Again, there were alterna- tives here, Should they invest inthis immediately after the brewery was bull, ata later date or not investinit at alland ‘continue through their current distributors? The investment Inthe brewery, especially fetter distribution systems were to.be developed, in turn opened up ather options, Currently being discussed, for example, was whether there existed a market opportunity to develop and produce beers tailored more specially to the Indian market. Again, should there be investmentin thissoon after the building ofthe brewery, ‘ata ater date, o not ata? kwas aso recognised that other ‘options might emerge if the project went forward, Development of ‘The board used a real options approach, not least because they needed to factor in the potential added value ‘of the options opened up by the brewery. They would employ OCF to evaluate the brewery project. However, they would also evaluate the other options assuming the brewery was built. In each of these evalu- ation exercises DCF would also be used, adjusting the cost of capital tothe perceived rsk of the options, This would give them an indication ot NPV tor each of those options. ‘The possible postive NPVs ofthe subsequent options could then be taken into account in assessing the attractiveness of| ‘the initial brewery project “They also recognised that, if heyinvested in the brewery 430 as to further develop their presence in India, greater clarity on both costs and market opportunities would emerge asthe project progressed, So it would make sense ‘to revisit the evaluation of the other options at later stages, as such information became avaiable Question ‘What are the advantages of the real options approach to this evaluation over other approaches (a) to building the brewery; and (b} to other ideas being considered? Proguct imbremery “dstibuton iversfeation ‘capability Invest now vest now Invest later Invest now vest ater ‘Stop investment Invest later Stop investment Stop investment 387Chapter 12 Fvaluating strategies 388 projects (and strategies) tend not to receive support. The real options approach, on the ‘ther hand, tends to value higher more ambitious strategies. There have, therefore, been callsto employ real options together with more traditional financial evaluation such as DCF. In effect, OCF provides the cautionary view and real options the more optimistic view Note that a real options approach is more useful where a strategy can be structured in the form of options - for example, where there are stages, as in pharmaceutical develop- rment= such that each stage gives the possibility of abandoning or deferring going forward, ve the same advantages of flexibility to a project where major capital outlay was required at the beginning, 12.4.2 Risk ‘The second Ris the rik an organisation faces in pursuing a strategy. Risk concems the extent to which strategic outcomes are unpredictable, especially with regard to possible nega- tive outcomes. Risk s therefore linked with outcome, return, so that a higher risk is gener- ally associated with the chances ofa higher return and a lower rsk with lower return= the so-called "iskcreturn tradeof’. The reason that higher risk is associated with higher return is that more time and effort are generally needed to obtain information and to monitor progress, than for lower risk investments, If an investment has @ high risk and low return, itis kly investors would seek to leave that investment for another, so driving up the level of return, Similarly, for an investment with low risk and high return, more investors would want to be involved, thus driving down the return. Risk can be high for organisations with major long-term programmes of innovation, or where high levels of uncertainty exist about key issues in the environment, or where there are high evels of public concern about new developments ~ such as genetically modified crops.” A key issue is to establish the accept- able level of risk or the organisation. Is the organisation prepared to ‘bet the company on a single strategic initiative, risking total destruction, or does it prefer a more cautious approach of maintaining several less unpredictable and lower-stakes initiatives? Formal risk assessments are often incorporated into business plans as wel asthe investment appraisals of major projects. Chosen strategies should be within the limits of acceptable rsk forthe organisation. Young entrepreneurs may have a higher tolerance for risk than established family businesses, for example. Importantly risks other than ones with immediate financial impact shouldbe included, such a sk to corporate reputation or brand image. Developing a ‘900d understanding of an organisation's strategic position (Part! of this book) isatthe core of good risk assessment However, the following tools can also be helpfulin ariskassessment, Sensitivity analysis'® Sometimes referred to as whatif analysis, sensitivity analysis allows each of the important assumptions underlying 2 particular strategy to be questioned and challenged. In particular, it tests how sensitive the predicted performance outcome (e.g. profits to each of these assumptions. For example, the key assumptions underlying a strategy might be that market demand will grow by 5 per cent a year, or that a new product willachieve a given sales level, or that certain expensive machines will operate at 90 per cent loading. Sensitivity analysis asks what would be the effect on performance (for example, profitability) of variations on these assumptions. For example, if market demand grew at only 1 per cent, or by as much as 10 per cent, would either of these extremes alter the decision to pursue that strategy? This can help develop a clearer picture of the risks of making particular strategic decisions and the degree of confidence managers might have in a given decision. Illustration 12.5 shows how sensitivity analysis can be used12.4 Acceptability Illustration 12.5 sensitivity analysis Sensitivity analysis is a useful technique for assessing the extent to which the success of a preferred strategy is dependent on the key assumptions that underlie that strategy. In 2019 the Dunsmore Chemical Company was a single product company trading in a mature and relatively stable market, It was intended to use this established situation ‘asa ‘cash cow’ to generate funds for a new venture with 2 related product. Estimates had shown that the company would need to generate some £4m (€4.4m; $6m) cash between 2020 and 2025 for this new venture to be possible [Although the expected performance of the company was {for a cash flow of £9.5m over that period (the base case management were concerned to assess the likely impact of three key factors: + Possible increases in production costs (labour, overheads and material), which might be as much as3 percent pa In real terms. + Capacity, whieh might be reducedby as much as 25 per cent due te ageing plant and uncertain labour relations. 3 2.00 i = {2) Sensitivity of cash flow to changes in eal production costs 4 (b) Sensitivity of cash flowto changes in slant utilisation 3.000 6 Se | 2a 2o20[ zip mapa 2pa_zopa aps {Sensitivity of eash flow to recuctions in eal price + Price levels, which might be affected by the threatened entry of a new major competitor. This could squeeze prices by as much as 3 per cent pa. in real terms. was decided to use sensitivity analysis to assess the possible impact of each of these factors on the com- pany’ ability to generate £4m. The results are shown inthe graphs From this analysis, management concluded that thelr target of £4m would be achieved with capacity utilisation as low as 60 per cent, which was certainly going tobe achieves. Increased production costs of 3 per centp.a. wouldstil allow ‘the companyto achieve the £4m target over the period. In contrast, price squeezes of 3 per cent pa. would result in a shortfall of 2m, ‘Management concluded from this analysis thatthe key ‘actor which should affect hele thinking on this matter was ‘thelikely impact ofnew competition and the extent towhich they could protect pric levels ifsuch competition emerged. They therefore developed an aggressive marketing strategy to deter potential entrants Questions What shoul the company do fits marketing campaigns fll top real price erosion 41 Push to achieve mara sles volume/capaciy fi? 2. Recuce unit oxo production? 2 Something else? 389Chapter 12 Fvaluating strategies 390 Financial risk’? Financial risk refers to the possibility that the organisation may not be able to meet the key. financial obligations necessary for survival. Managers need to ensure that strategies meet acceptable levels of financial risk. Two key measures are important here, First, there is the level of gearing, the amount of debt the company has relative to its ‘equity, Strategies that increase the gearing (or ‘leverage’) of a company also raise the level of financial risk. Ths is because interest payments on debt are mandatory and inflexible: if performance dips and the interest cannot be paid, the company risks bankruptcy ‘A second kind of financial risk measure relates to an organisation's liquidity. Liquidity refers to the amount of liquid assets (typically cash) that s available to pay immediate bill Many businesses fail not because they are inherently unprofitable, but because of a lack of liquid assets, whether their own or obtained through short-term loans. For example, a small manufacturer with a rapid growth strategy may be tempted to take on lots of orders, but then find that they have to pay their suppliers for the raw materials before they actually receive the payments for the goods they have produced. Again, a company that cannot pay ite ills risks bankruptcy. Break-even analysis Break-even analysis? is a simple and widely used approach which allows variations in assumptions about key variables in a strategy to be examined. It demonstrates at what point in terms of revenue the business will recover its fixed and variable costs and therefore break ‘even. It can therefore be used to assess the risks associated with different price and cost structures of strategies as shown in ilustration 126. 12.4.3 Reaction of stakeholders The third Ris the likely reaction of stakeholders to a proposed strategy. Section 5.2.2 showed how stakeholder mapping can be used to understand the political context and consider the political agenda in an organisation. It also showed how stakeholder mapping can be used to consider the likely reactions of stakeholders to new strategies and thus evaluate the accept- ability ofa strategy, There are many situations where stakeholder reactions could be crucial Chapter 5 covers a range of stakeholders but the following show how they may evaluate strategy differently. For example: *+ Owners (e.g. shareholders, including private individuals as well as investment funds, venture capitalists, private equity, family owners, the state) will have financial expect- ations to be met so that a proposed strategy that might reduce profitability or dilute thelr voting power is likely to be unacceptable, + Bankers and other providers of interest-bearing loans are concerned about the risk attached to their loans and the competence with which this is managed. The extent to which a proposed strategy could affect the capital structure of the company could be a concern if, for instance, it would increase the gearing ratio (of debt to equity), which indicates how sensitive the company’s solvency's to changes nits profit position. Similarly a reduction in interest cover, that shows the extent to which profits can cover interest payment, would be of concern to bankers as would be changes in a company's liquidity, as deterioration may mean the need for additional loans and a change in the company's risk profile. So a key question is: how will the proposed strategy affect liquidity? + Government agencies and regulators are important stakeholders in industries such as telecommunications, financial services, pharmaceuticals and power. They may have what12.4 Acceptability Illustration 12.6 Using break-even analysis to examine strategic options Break-even analysis can be a simple way of quantifying some of the key factors which would determine the success or failure of a strategy. ‘A manufacturing company was considering the launch of ‘a new consumer durable product into a market segment where most products were sold to wholesalers which supplied the retal rade, The tozal market was worth about -€48.m (or $6.6m) (at manufacturers’ prices) about 630,000 Units, The market leacer had about 20 per cent market share ‘na competitive market where retailers were increasing their buying power, The company wished to evaluate the relative merits of ahigh-price/high-qualty product sold to whole- sales (strategy A) or an own-brand product sold directly to retailers (strategy 8). ‘The table summarises the market and cost structure for ‘the market leader and these akernative strategies. “The table shows that the company would require about 22 per cent and 13 per cent market share respectively for strategies A and 8 to break even, Questions 1 Which option would you choose? Wy? 2 What would be the main ris attached to that option an how wouldyou attempt to minimise thes sks? 3 Create another option strategy Cand exalain the kind of brealceven profile which would be needed to make Iemore attacve than esther strategy Aor srategyB Price to retailer Price to wholesaler “otal variable costs (VC) Contribution to profit per unit sold (= Pree sold-TVC) Fixed costs (FC) Break-even peint:no. of units to sell (= FC/Centribution to profit) “otal market size (units) nt: market share Break-even reak-even point units/ Mut size) ‘Actual marketshare 10.00 12.00 700 8.40 - 350 400 3.10 350 440 490 500,000 500,000 500,000 142,887 113.636 102,040 630,000 630,000 630,000 2.6% 18.0% 162% 300% E .Chapter 12 Fvaluating strategies amounts to decision-making powers over aspects of an organisation's strategy, such as price of geographic expansion. + Employees and unions and local community may resis strategic moves such as relocation, outsourcing or divestment if they see them as likely to result in job losses. Matters of business ethics and social responsibility were discussed in Section 5.4, + Customers may also object to a strategy and switch their business to a competitor. For example, a new business model, such as marketing online, might run the risk of a backlash from existing retail channels, which could jeopardise the success of the strategy, Overall, there isa need to be conscious of the impact on the various stakeholders of the strategic options being considered, Managers also need to understand how the capability, to meet the varied expectations of stakeholders could enable the success of some strategies while imiting the ability of an organisation to succeed with other strategies. 12.5 Feasibility 392 Feasibility is concerned with whether a strategy could work in practice: in other words, ‘whether an organisation has the capacity to deliver a strategy. An assessment of feasibility Is likely to involve two key questions: (a) do the resources and capabilities currently exist to implementa strategy effectively? And (b) ifnot, can they be obtained? These questions can be applied to any resource area that has a bearing on the viability of a proposed strategy, Here, however, the focus is on three areas: finance, people (and their skills) and the import ance of resource integration, 12.5.1 Financial feasibility central issue in considering a proposed strategy/s the funding requited fort. tis therefore importante forecast the cash flow" implications ofthe strategy. The need sto identify the cash requited fora strategy, the cash generated by following the strategy and the timing of any new funding requirements. This then informs consideration of the likely sources for obtaining funds Managers need to be familiar with different sources of funds as well as the advantages and drawbacks of these. This is well explained in standard financial texts? This is not only a matter of the feasibility ofa strategy, but also its acceptability to different stakeholders, hot least those providing the funds, So the discussion in Section 12.4s relevant here too. Decisions on which funding sources to use wil also be influenced by the current financial situation of the organisation such as ownership (e.g. whether the business is privately held or publidy quoted) and by the overall corporate goals and strategic priorities ofthe organisa- tion. For example, there willbe different financial needsifa business is seeking rapid growth by acquisition compared with if itis seeking to consolidate its past performance. ‘A.useful way of considering funding is in terms of which financial strategies might be needed for different ‘phases’ ofthe lifecycle of a business (as opposed to an industry life cycle). The folowing describe each life-cycle stage and funding implications + Start-up businesses”? are high-risk businesses, They are at the beginning of their life cycle and are not yet established in their markets; moreover, they are likely to require substantial Investment. A stand-alone business in ths situation might, for example, seek to finance such growth from specialists in this kind of investment, such as venture capitalists who, themselves, seek to offset risk by having a portfolio of such investments. Schemes for private investors (so-called ‘business angels’) have also become popular. Providers of such12.5 Feasibility funds are, however, likely to be demanding, given the high business risk, Thus venture ‘capitalists or business angels typically require a high proportion of the equity ownership in exchange for even quite small injections of funds. + Growth businesses may remain in a volatile and highly competitive market position. The degree of business risk may therefore remain high, as will the cost of capital in such circumstances. However, if a business in this phase has begun to establish itself in its markets, pethaps as a market leader in a growing market, then the cost of capital may be lower. In either case, since the main attractions to investors here are the product or bust ness concept and the prospect of future earnings, equity capital is likely to be appropriate, perhaps by public flotation, + Mature businesses are those operating in mature markets and the likelihood is that funding requirements will decline. If such a business has achieved a strong competi- tive position with a high market share, it should be generating regular and substantial surpluses. Here the business risk is lower and the opportunity forretained earningsis high. In these circumstances, if funding is required, it may make sense to raise this through debt capital as well as equity, since reliable returns can be used to service such debt, Provided Increased debt (gearing or leverage) does not lead to an unacceptable level of risk, this cheaper debt funding will in fact increase the residual profits achieved by a company in these circumstances. * Declining businesses are likely ta find it difficult to attract equity finance. However, borrowing may be possible if secured against residual assets in the business. At this stage, itistkely that the emphasis in the business will be on cost cutting, and it could well be that the cash flows from such businesses are quite strong, Risk is medium, especially if decline looks to be gradual. However, there is the chance of sudden shake-out with battles for survival These life-cycle stages and funding implications are shown in Table 12.4 This life-cycle framework does not, however, always hold. For instance itis common for companies to invest in new ventures, services, technologies to develop new and innovative businesses in order to survive long term. Doing this on a regular basis might, in effect, be acting as ts own venture capitalist, accepting high risk at the business level and seeking to offset such risk by ‘cash cows’ in its portfolio (see Section 8,7), Or some companies may need to sel off businesses as they mature to raise capital for further investment in new ventures, Publc-sector managers know about the need to balance the financial risk of services too. They need a steady core to their service where budgets are certain to be met, hence reducing ‘the financial risk of the more speculative aspects of their service ‘Table 12.4 Financial strategy and the business life cycle Startup High High High ——Personaldebtsequity langel Zero land venture capital) Growth High Low! High Debentures and equity Minimal sedi {growth investor) Maturity Lowimedium Medium Medium Debt, equity and retained High earings ExivDecline Low/negative Medium/ Medium Debt, retained earings High high 392Chapter 12 Fvaluating strategies 12.5.2 People and skills Chapter 4 showed how organisations that achieve sustainable competitive advantage may do so on the bas's of resources and capabilities that are embedded in the skils, knowledge and experience of people in that organisation. Indeed, ultimately the success of strategy will likely depend on how itis delivered by people in the organisation. These could be managers but they could also be more junior people in the organisation who are nonetheless critical to.a strategy, for example as the frontline contact with customers, Three questions arise: do people in the organisation currently have the competences to deliver a proposed strategy? ‘Are the systems to support those people ft for the strategy? If nat, can the competences be obtained or developed? ‘The first step here's the same as suggested in Section 12.3.1 for the screening for compet- itive advantage, The need is to identify the key resources and capabilities underpinning a proposed strategy, but specifically in terms of the people and skills equired. The second step. is to determine if these exist in the organisation. it could be, of course, that the proposed strategy is built on the argument that they do. If so, how realistic is this? Orit could be that the assumption is that these can be obtained or developed. Again, is this realistic? Many of the issues of feasibility in relation to the structures and systems to support such competence development and people are addressed in Chapter 14 on organising and Chapter 15 on leading strategic change. Other critical questions that need to be considered include? + Work organisation. Will changes in work content and priority-setting significantly alter orientation of people's jobs? Will managers need to think differently about the tasks that need to be done? What are the critical criteria for effectiveness needed? Are these different from current requirements? + Rewards, How will people need to be incentivised? Will people's career aspirations be affected? How will any significant shifts in power, influence and credibility need to be rewarded and recognised? + Relationships. Will interactions between key people need to change? What are the conse- quences for the levels of trust, task competence and values-congruence? Will conflict and political rivalry be likely? + Training and development. Are current training and mentoring systems appropriate? It may be necessary to take into account the balance between the need to ensure the successful delivery of strategy in the short term and the required future development of people's capabilities, + Recruitment and promotion. Given these issues, will new people need to be recruited into ‘the organisation, or can talent be promoted and supported from below? 12.6 Evaluation 394 Evaluation is concerned with identifying strategies that can pass all the hurdles of suit- ability, acceptability and feasibility, This is an important stage in the selection process as strategies that may appear excellent under one criteria may fail under another. To take account there may be conflicting conclusions, there needs to be a synthesis of the strategies12.6 Evaluation selected from the analysis of suitability, acceptability and feasibility, so that the chosen strategy works fr all, This often means that strategies that seemed superior ear ‘the process atthe su'tabilty stage may either drop out of require significant adjustment ‘o contmuesOften the chosen strategy is less about what s‘best’,and more about what is, possible 12.6.1 Three qualifications ‘There are three qualifications that need to be made about evaluation criteria: + Management judgement. Conflicting conclusions can arise from the application of the criteria of suitability, acceptability and feasibility and its therefore important to remember that the criteria discussed here are useful in helping think through strategic options but are not a replacement for management judgement. Managers faced with a strategy they see as suitable, but which key stakeholders object to, have to rely on their own judgement ‘on the best course of action, but this should be better informed through the analysis and evaluation they have undertaken, + Consistency between the different elements ofa strategy. It should be clear from the chap: ters in Part Il that there are several elements of a strategy, so an important question is whether the component parts work together as ‘package’. SBicompeutivestrategyiSUeh) ‘iralllanges)ineed to be considered as a whole and be consistent. There are dangers if they are not. For example, suppose an organisation wishes to develop a differentiation strategy by building on its capabilities developed over many years to develop new prod: ucts or services within a market it knows well. here may be dangers in looking to develop those new products through acquiring other businesses which might have very different ‘capabilities that are incompatible with the strengths of the business. + The implementation and development of strategies may throw up issues that might make organisations reconsider whether particular strategic options are, in fact, feasible ‘or uncover factors that change views on the suitability or acceptability of a strategy. This, may lead to a reshaping, or even abandoning, of strategic options. It therefore needs to be recognised that, in practice, strategy evaluation may take place through implementation, ‘rat least parcial implementation. [hisis@notherreasonlWhylexperimientationjlow=cost robes and real options evaluation may make sense, + Strategy development in practice. More generally, it should not be assumed that the careful and systematic evaluation of strategy is necessarily the notm in organisations. Strategies may develop in other ways. This is the subject of Chapter 13 which follows. The final chapter, Chapter 16, also explains what managers actually do in managing strategic issues.Chapter 12 Fvaluating strategies Thinking differently Misrepresenting strategic projects Financials play an important role in strategy evaluation (Section 12.4.2) and they ean appear be accurate repre: sentations of value, yet should we trust them? Research into mega-strategi¢ projects such as the German Ber to Hamburg MAGLEY train, Hong Kong's airport, China's Quinling tunnel suggests many underperform badly with large cost overruns and lower than predicted revenue.” For example, the £4.7bn England to France Channel ‘Tunnel had cost overruns of 80 per cent, financing cost Increase of 140 per cent and less than half projected revenues. Milions in debt were written of for the project +o survive, The UK may have been financially better off without It. Retrospectively, commentators often denounce strategic project figures as ‘biased, seriously ‘awed; representing deception and ies While blamed upon external factors such as unex: pected events, stakeholder actions or regulatory Constraints, underperformance may be due to strategic _misrepresentation that distorts the resource allocation process, Itexists as persistent budget overruns and over- estimations of benefits on strategic projects ought to have been reduced by now through improved budgeting processes, It cannot be blamed on ‘optimism bias, individual self-deception that results in others being deceived, asitis deliberately designed to deceive others Strategic misrepresentation advocates a perfect ‘future, which is unlikely to happen, with benefits that are used to enthuse investors. While Section 12.2.4 recognises CEOs communicate to ensure favourable Interpretations of strategic initiatives, strategic misrep~ resentation isa deliberate distortion of financials based fon a future that cannot be realised, to mislead investors +0 buy-in, Once deceived into committing substantial funds, budgets escalate and investors are locked in, with no chance of getting a return unless the project is completed. Be careful that financials are not being used to deceive stakeholders into supporting strategic projects. Look more closely at the fundamental strategic attractiveness of the strategic option to avoid another project ‘failure Question What strategic fundamentals would you consider fora strategic option if you didn’t trust the numbers? Summary 396 + Performance can be assessed in terms of both economic performance andl overall organ- \sational effectiveness. + Gap analysis indicates the extent to which achieved or projected performance diverges from desired performance and the scale of the strategic initiatives requited to close the gap. + Strategies can be evaluated according to SAFE: suitability in view of organisational ‘opportunities and threats, acceptability to key stakeholders, feasibility in view of capacity for implementation and evaluation in terms of strategies that meet all criteria. + Suitability of strategic options can be assessed by using ranking, screening through scenarios and decision tre analysis. + Acceptability takes into account Return (ROCE, payback, DCF, SVA cost benefit, real options analyses) Rsk sensitivity analysis and financial risk) and stakeholder reactions (stakeholder mapping). + Feasibility considers financial viability and the need to consider key resources and capabil- ities throughout the business life ede.Recommended key readings Work assignments “Denotes more advanced work assignments * Denotes case study in the Text and Case edition, 12.4. Identify a quoted company (perhaps a company that you are interested in working for) and assess its share-price performance over time relative to relevant national stackcmarket indices (e.g. SEP 500 for the US, CAC 40 for France or FISE 100 for the UK) and close competitors. (Sites such as Yahoo Finance or MSN.Money provide rele- vant data for free.) 12.2. Undertake a ranking analysis ofthe choices available to ITV, Oak Tree Inn or an ‘organisation of your choice similar to that shown intlustration 12.2, 123. Using the criteria of suitability, acceptability and feasibility undertake an evaluation of the strategic options that might exist for ITV, Oak Tree Inn, Mexican NTOs, Grand Strategies in Vision ot an organisation of your choice. 12.4 Undertake a tsk assessment to inform the evaluation of strategic options for an organisation of your choice. 125. Write an executive report on how sources of funding need to be related to the nature of an industry and the types of strategies that an organisation is pursuing. 112.6% Using examples from your answer to previous assignments, make a critical appraisal of the statement that ‘Strategic choice i, in the end, a highly subjective matter. Its dangerous to believe that, in reality, analytical techniques will ever change this situ- ation’ Refer to the commentary at the end of Part of the book. Integrative assignment 12.7% Explain how the SAFE criteria might dlfer between public-and private-sector organisations. Show how this relates to both the nature of the business environment (Chapter 3) and the expectations of stakeholders (Chapter 5) Recommended key readings + Readers may wish to consult one or more standard ‘texts on finance. For example: . Arnold, Corporate Financial Management, Sth edition, Financial Times Prentice Hall, 2012; . Ati, Financial Management for Decision Makers, 7h edition, Pearson, 2014, + Aclassicpaper that considers the relationship between financial approaches to evaluation and ‘strategic’ approaches is P. Barwise, P. Marsh and R, Wensley, ‘Must finance and strategy clash?" Harvard Business Review, September-October 1988, + RSS Kaplan and D.P. Norton have been very influen- tial ina series of books in providing techniques for evaluation strategy. A useful paper of theirs that ‘examines the link between performance measure ment and strategic management is"Transforming the balanced scorecard from performance measurement to strategie management: Part. Accounting Hori- z0n5, vol. 15,1. March (200%), pp. 87-104, For a review of a wide range of tools and techniques Instrategic management, including those elated to strategy evaluation, see T. Vuorinen, H. Hakala, Mt Koltamak’ and K, Uusitalo, ‘Mapping the landscape of strategy tools: a review on strategy tools published inleading journals within the past 25 years, Long Range Planning (2017), htip//dxdol.org/10.1016/ 1np.2017.06.005, 397Chapter 12 Fvaluating strategies References 398 This distinction between economic and effectiveness measures follows the distinction between perform: ance and effectiveness in P. Richard, T. Devinn, G. Yip and 6. Johnson, 'Measuting organizational perfor: mance: towards methodological best practice’, Journal ‘of Management, vol. 35 (2009), pp. 718-47, R. Kaplan and DP Norton, ‘Using the balanced score- ‘cardasa strategic management system’, Harvard Busi ness Review, Jan-Feb (1996), pp. 75-85, RS. Kaplan and OP. Norton, ‘Transforming the balanced scorecard from performance measurement tostrategicmanagement-Part Accounting Horizons, vol. 15,no. 1, March (200), pp. 87-104, \wwswsustainabiltyreport. Heineken.com R. Mergenthaler, 5. Rajgopal and S. Srinivasan, ‘CEO and CFO Career Penalties to Missing Quarterly ‘Analysts Forecasts, Harvard Business School Working Paper, no. 14 (2008) R. Wiggins and T. Ruefli, “Temporal dynamics and the incidence and persistence of superior economic performance’, Organization Science, vol. 13, no. 1 (2002), pp. 82-105. 41. Denrel, ‘Selection bias and the perils of bench. marking’, Harvard Business Review, val. 83, no. 4 (2005), pp. 114-9. K. Cohen and R. Cyer, ‘Strategy: formulation, imple- mentation, and monitoring,’ Journal of Business, vol. 46, no. 3 (1973), pp. 349-67. X. Zhang, & Bartol and K, Smith, ‘CEOs on the edge: ‘earnings manipulation and stock-based incentive misalignment’, Academy of Management Journal, vol.51, no. 2 (2008), pp. 241-58, B, Lev, “How to win investors over’, Harvard Business Review, Novernber (2011), 53-62. Sawhil and Willamson, D, ‘Measuring what matters in nonprofits, The McKinsey Quarterly, vol. 2 (200%), pp. 98-107; M, Epstein and R, Bukovac, Performance ‘Measurement of Not-For-Profit Organizations, Manage- ment Accounting Guidelines, CMA AICPA, 2008. Most standard finance and accounting texts explain in more derail the financial analyses summarised here. For example, see 6. Arnold, Corporate Financial ‘Management, ath edn, Financial Times Prentice Hal 2009, chapter 5 There are other measures of return including ROE, RO! and ROA. ROE (return on equity) measures the eff ciency of the firm in generating profit for each share. ROI (return an investment) - shows how profitable a ‘company’s assets are in generating revenue. Real options evaluation can get lost in the math: fematics, so readers wishing to gain more detail of how real options analysis works can consult one of 20. a 2. 23, 24, 25, following: T. Copeland, The real options approach ‘capital allocation’, Strategic Finance, vol. 83, n0. 4 (2001), pp. 32-7; and P. Boer, The Real Options Solu tion: Finding Total Value in a High Risk World, Wiley, 2002, Also see M.M, Kayali,'Real options as a tool for making strategie investment decisions’, Journal of American Academy of Business, vol. 8, no. 1 (2008), ppp. 262-7; C Krychowski and BV. Quelin,'Real options and strategicinvestment decisions: can they be of use to scholars?", Acaciemy of Management Perspectives, vol. 24, no. 2 (2010), pp. 65-78. T. Luehrman, ‘Strategy as a portfolio of real options’, Harvard Business Review, vol. 76, no, 5 (1998), pp. 89-98 ‘Areal’ option differs from a financial option, such as put or all option, asthe latter ae traded as secur- ities and the holders of financial options are generally not the managers who may make decisions on the underlying project IM. Friga and R, Anderson, ‘Strategic risk manage- ment, Journal of Corporate Accounting and Finance, vol. 22, no.3 (2011), pp. 81-88. For those readers interested in the details of sensi- ‘ivity analysis se: A, Satelli,K, Chan and M, Scot (eds), Sensitivity Analysis, Wiley, 2000, See C. Walsh, Master the Management Metrics That Drive and Control Your Business, Financial Times Pren- ‘ce Hall, 4th edition, 2005. Break-even analysis is covered in most standard accountancy texts. See, for example, 6. Arnold, Corporate Financial Management, 4th edition, Finar- cial Times Prentice Hal, 2003. See G. Arnold on funds flow analysis (ref. 4 above), Chapter 3, p. 108, See: P. Atrill, Financial Management for Decision Makers, 4th edition, Financial Times Prentice Hall, 2006, Chapters 6 and 7; G, Arnold (endnote 12), Parti J. Nofsinger and W. Wang, ‘Determinants of start-up ‘firm external financing worldwide’, Journal of Banking and Finance, vol. 35,0, 9 (2011), 2282-94, “These issues are based on those identified by C. Marsh, P. Sparrow, M. Hird, S. Balain and A. Hesketh (2008) Integrated organization design: the new strategic priority for HR directors, in PR, Sparrow, A. Hesketh, ©. Cooper and M. Hird (eds) Leading HR, London: Palgrave Macmillan. ‘hiss based upon G. Winch, Managing Construction Projects, Oxford, Blackwell Wiley, 2010, and | Dichev, J. Graham, CR. Harvey and S, Rajgopal, The misrepre- sentation of earnings’, Financial Analysts Journal, vol 72,n0.1 (2016),ITV: DIY, buy or ally? Case example ITV: DIY, buy or ally? Duncan Angwin In 2016 ITV was the UK's largest commercial broadcaster ‘and second only in size to the BBC, a public-sector organ- isation. ITV produced creative content and broadcasting for different audience targeted channels, Capitalised at £9.6bn (€11.Sbn; $14.4bn) the main source of TV's revenue came from advertisers buying slots to air thelr advertisements on its channels. Revenues had increased steadily over the five years to 2015, to £2.972bn, a 15 per cent year-on-year improvement, and pre-tax profits ‘to £810m, but ITV was now facing challenges. The tele vision advertising market had become saturated, and new online media was proving attractive to advertisers as Viewing habits among the younger generation were ‘changing, There was also the possibilty of changes to UK. legislation. ITV needed to develop a strategy to address these issues. ITV's market position Prior to 2016 ITV had gained its position as the UK's largest commercial broadcaster through a unique blend ‘of content, broadcasting reach and advertising power (see Figure 1). ‘As an integrated producer broadcaster ITV created. value from world-class content that it developed, owned and distributed around the world, The scale of its free and pay platforms and its €1bn annual investment in its programme budget attracted commercial audiences that drove ts advertising revenue. Ithad increased itslead over itsmain competitors with more than double the TV adver- ‘ising revenue of public sector broadcasters (£650m) and, ‘Channel 4/54 (£450m) in 2015, although TV accounted, ‘for just over 24 per cent of UK advertising spend and was growing at 3 per cent per annum while digital media attracted just over 50 per cent of advertising spend and ‘this was growing at an annual rate of 9.5 per cent ITY attributed its success to the provision of high- quality content as it attracted a high volume of viewers and this enticed advertisers to place their adverts on their channels, Some of ITV's drama and reality shows were already more popular than the 88C with Downton Abbey beating Sherlock and Doctor Who. It also invested significantly in acquiring intellectual property rights and financed praductions on and off ITV ‘to gain global distribution rights. As the UK's biggest marketing platform its channels also enabled it to showease ts own content that could then be sold inter- nationally. As the demand for proven content continued ‘to grow, ITV has been diversifying and driving new revenue streams, TY had developed its own online platform in 2007 called ITV player. Although it had attracted viewers, it was ranked just eighth in the UK in 2015, along way behind ‘YouTube with 50 per cent and BBC Player with 37 per cent of the UK digital services market (see Figute 2). AAs wel as developing its online and pay revenue, it bul. a global network in the development, production and distribution of content. Through investment in creative pipeline and strategic acquisitions in key creative markets, such as the acquisition of Talpa Media 84. for £796m that produced The Voice, | Love My Country and Dating in the Dark itwas building scale in itsinternational content bust ness, exploiting programmes and formats that travel Figure 1 The UK television viewing share 2014 © rv Family 22.0% BBC Family 32.9% © Channel 4 Family 10.9% Five Family 59% Sky Family 33% © other 20.0% . 399‘Chapter 12 Evaluating srategies Figure 2 ‘This statistic displays the leading digital content sevice inthe United Kingéom ranked by usage among digital content consumers as of May 2015. YouTube ranked fist, wth 50 percent of respondents reporting having used the servic to consume or share cial content within the three months previous tothe survey. YouTure BC Player AmazoniAmazon mp3ikinale Nest iTunesgp Sloeidookstorelapole Stowe Facebook Google (Search Engine ITV Player 0% 10% 20% 30% 40% 50% 60% Figure 3 ITV studio revenue 2013 to 2014 ITV Stueios total revenue tracker em 960 900 850 800 Dee 13. Organic UK Organic Inter. Global FX ~Dee A UK scqui- inter- national entertain- impact produe- sitions national acqui- ment tions productions sitions Source IV Annual Reper: (2015). 400ITV: DIY, buy or ally? Figure 4 Revenue breakdown Broadcast and online m9 1629 (Multiple delivery platforms) Advertsing Non-advertising 29 298 Tv studios 1085, 789 {International content business) averting Non-advertising 192 148 Total 2383 2956 Source TY Banya per (2015. ITV's resources and capabilities ITV's strategic assets were high-quality content (ITV, Studios), brand, excellent creative, commercial and oper- ational people. Interms of financal performance, revenue from ITV studios had increased 384 per cent from 2008 to 2014 (igure 3). This was driven through purchased international content and organic productions. International distribu- tion and pay TV also continued to grow but broadcasting ‘and online remained the main source of revenue in 2015 (Gee Figure 4). These supported a strong balance sheet ‘that generated free cash flow of £0.5bn (2015). In terms of other resources ITV owned large content library of 40,000 hours and operated eight network channels, more than any other UK commercial network. Its strong financial resources and large viewing numbers ‘gave it considerable power in winning licences to show live functions and sports events. Investing in a portfolio of ‘channels and digital assets to reach all demographics also ‘extended the brand, Human resources were supported through training and development. ITV had world-class production capabilities and it ‘owned several production companies and studios. TV continuously improved its output and quality, providing 60 per cent of ITV's total channel broadcasting output. italso purchased content from external studios. Content, advertising and broadcasting were of central importance ‘to ITV, giving it advantages over competitors such as the BEC ith strong content and broadcasting vatiety but no advertising and Netflix with much less content and only ‘one medium of distribution, Online threat Different entertainment platforms such as online TV and Internet had been growing rapidly in the UK. he tradi- tional TV broadcasting industy still had a per annum ‘growth rate of 3.1 per centbut the market was becoming saturated and slowing down, Over the same period online TV viewing grew by 38 per cent stimulated by recent online video-on-demand (VOD) libraries, such as Netix, the world’s largest VOD provider with 42m subseribers, ‘capitalised at $33bn, Amazon Prime and Hulu Third ranked Hulu, a joint venture with nine milion subscribers, worth about $10bn (£6:7bn), was seen as a real threat to Netflix Although it struggled to find quelity| content for distribution, is parents, Disney Fox Broadcasting and NECUniversalhelped to some degree, Hulu had tied to set upa distribution agreement for the UK with ITVin 2010, butt didn't work out. However, in 2016 Time Warner was ‘tying to buya25 per centstake to hedge itselfagainst Hulu streaming service cannibaliing its TV business although the returns would be low. It would also be a source of cash for Hulu investors seeking to monetise their investment. By 2015 the Internet (43.9 per cent market share), had overtaken television (27.6 per cent), as the biggest adver {ising platform in the UK. ITV lagged behind in the online content delivery business. There were many complaints and poor reviews about the ITV Hub platform and customers were choosing competing platforms such as BC Player. This was attributed to technical isues withthe catch-up TV platform, called ITV player, and to some extent ‘he advertisements shown while streaming the content. BBC's catch-up TV was superior and so ITV re-launched the ITV player asITV Hub with new features: live TV along with programme catch-up could be aired on all TV channels 0 that they could be streamed for 30 days from the day of broadcasting, However there was strong competition ‘with new platforms from Nettlix, Amazon Prime and HBO Go gaining in popularityamong viewers in the 15-35 age group. ITV therefore considered offering advertisement: free content, for a monthly subscription fee, on a new platform which would cost around £20m to putin place ‘This would attract viewers who were deterred by earlier 401Chapter 12 Evaluating strategies ITV online services that had advertisements. This would be although TV would also be seriously challenged in terms a subscription-only service, and would generate income of competing for advertising revenue. Due to the BBC's ‘that could reach £100m in five years. power in the broadcasting market, prospective changes ITV Hub was only for UK audiences and the new plat- could impact the whole broadcasting industry, and ITV form would be the same. It did not have direct experience would probably lose its place as the biggest commercial land knowledge of global online VOD as it only sold its platform in the UK. content to global broadcasting or online VOD companies In addition, the government was also considering rather than providing the platform. Amazon Prime and whether to privatise Channel 4, through a public affering Netflix already operated worldwide and the global online of shares or even sale to anather company. Analysts est= ‘VOD market was likely to be a very important source of mated this would bring around f2bn into the government's growth n the future, However, most VOD operatorsstiug- coffers which would help bring down some of thenaticnal gled to obtain large volumes of superior contentandallof debt. Channel 4 had a good reputation for its content ‘them were signing deals for specific shows. For instance, quality, had its own content library, recording studios Hulu signed up for the rights to distribute Seinfeld for and broadcasting capability and would be attractive to 160m. Alliances and joint ventures were common in the other media operators. Although Channel 4 funded itself Industry and they had the attraction of being relatively through advertising, if the government decided to sell it, cheap to set up, measured in millions of dollars rather than this would have major implications fr the way itsbusiness billions, although very complex and time-consuming to was run, Channel 4 executives were said to be concerned negotiate, with theriseof termination along the way. thatthe organisation's bly to take creative risks would be undermined such thatrnaking programmes for unprf- Regulatory changes ible small siencesthateflactes the country’s utara diversity would ne longer be viable. As a commercialentity| Favourable government policies towards new internet {wri wow ro knoe Oe VOD plaformsin the UK were one of the majorinfvences on the broadastng industry. In adn, there was an active public debate about whether legislation concerning Cee eeen ee) ‘he BAC cence fee shouldbe changed. The BBC wae SWOT anaiyss had been prepared forthe board (see etry funded bythe public trough the lcence fee. f Table 1) that summarised the maln isaues facing ITV ‘he government decided to enditscharter the sBCwould in 2016 be forced to competewith commercial broadeasterssuch Faced with thestrategcisuesraiedin the SWOT anal 25 TV and Channel. The Impact would probably be ys the board of TV had to conser whether 1 should worse fr Channel 5 as much smaller entity than TV, pursue organi aronth, perhaps through developing its Table 1 MTV SWOT analysis + strong brand + Underperforming online delivery system + Strong balance sheet + TV Hubis UK only + Quality content + CEO about to change + Combnation of content, advertising and distribution + Growth of internet sistribution and online content *_Intemet as TV substitute delivery + Slow growth UK TV market + Content diversification + Advertisers turning away from TV advertising to internet ‘+ HD and 30 premium content offers + Younger generations prefer other media + Local television services over digital terestrial TV (OTT) » Demand side advertising platforms determine pricing platforms Subscription based on-demand only providers, e9, Net + Merger possibilities between tractional and ehain ‘Amazon Prime partners + Potential change to BBC status + Consumers prepated to pay for quality content * legal downloads + Privatisation of Channel 4 + New non-studio content 402ITV: DIY, buy or ally? production and online distribution activities, expansion ‘through acquisition and joint ventures, licensing agree- iments, restructuting of the company to specialise in just ‘one activity and perhaps even selling the business. Which strategic options should they consider and which one: should be pursued in the future? Sources: 'V pc AnnualReport and Accounts, 2015 Ofcom. The Com ‘munseivons Maret 2095 Wim, changes show Vi acing nthe bigger pure, The elegraph 18 lanuaty 2016 C. Willams, Wile» grand praetor ts buyer where te formal ours “lua on Channel The Telegrapny 26 Deeemoe" 215, Questions 1. dentiy the main strategic issues facing ITV. 2 Suggest a numberof strategic options that TV might pursue 3 Create tables to assess the SAFE ofyour strategie options refer to Table 121), 4 Rank your strategic options and recommend a strategy for TV to pursue, 403