Resource Allocation and Investment Strategies
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Transcript of Resource Allocation and Investment Strategies
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Strategy
&Capital Budgeting
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Strategy and Capital allocation
Capital budgeting is not the exclusive
domain of financial analysts, it is a
multifunctional task linked to a firmsoverall strategy.
Growth Strategies Expansion,
Modernisation, Diversification, Merger &Acquisitions
Allocation of Capital- As per Long Term
Strategies
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Objectives
What should be the strategic posture of the
firm for Growth ?
What pattern of resource allocation
subserves the chosen strategic posture ?
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Key Criteria
Increase in Shareholders Wealth is reflected
in :
Profitability - ROE = PAT / Net worth Risk- How much do individual outcomes
deviate from the expected value ? Risk interms ofRange of ROE
Growth Compounded rate of growth ofPAT
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Generic Strategies and Key
O
ptions Aggressive Concentric Diversification,
Concentration & Vertical Integration
Competitive Concentric Merger,ConglomerateMerger & Turnaround
Conservative Status Quo,Diversification &
Conglomerate Diversification
Defensive Divestment, Liquidation andRetrenchment
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Portfolio Planning Tools
Boston Consulting Group (BCG) Product
Portfolio Matrix
General Electrics Stoplight Matrix
Strategic Position And Action Evaluation
( SPACE)
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BCG Product Portfolio Matrix
Product Analysis on the basis of :
(a) Relative Market Share
(b) Industry Growth Rate
Stars
Question Marks
Cash Cows
Dogs
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BCG Product Portfolio Matrix
Relative Market Share
Industry
Growth
Rate
High Low
High Stars Question
marks
Low Cash
Cows
Dogs
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Stars
Products having high market share andhigh growth rate
Earn high profits and require additionalcommitment of funds for increasingproduction and sales.
As growth declines,additional investment
is not required and stars become cashcows.
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Question Marks
High Growth Potential but low market
share
Additional resources for improving marketshare and potentially converting them into
stars
But there is no guarantee that this wouldhappen. Thus, the question mark.
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Cash Cows
High Market Share but low growth
potential
Generate substantial profit and cash flowswith modest investment requirements
Cash surpluses provided by them are used
elsewhere in the business
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Dogs
Low market share and limited growth
potential
Since prospect is bleak,phasing out of theproduct is advised.
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Resource A ocat on
(Suggested Pattern)
Funds generated by Cash Cows should be
allocated to Stars and Question Marks
Funds released on divestment of Dogs
should be pooled and again allocated to therequirements of Stars and Question Marks.
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General Electrics Spotlight
MatrixStrong Average Weak
High Invest Invest Hold
Medium Invest Hold Divest
Low Hold Divest Divest
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Example
Rail Transportation as an industry hasmedium to low potential of growth & un-remunerativeness of any branch lines is anindicator of weak business strength. Forsuch branch lines, decision for divestment /strategic sale / leasing out etc. should beforced.
Whereas for Golden Quadrilateral, Industrypotential is High as well as for bulk trafficbusiness strength is high, hence we shouldinvest more here.
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Strategic Position And Action
Evaluation ( SPACE)
A Four Dimensional approach :
Companys Competitive Advantage
Companys Financial Strength
Industry Strength
Environmental Stability
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Company Competitive
Advantage Market Share
Product Quality & Life Cycle
Product Replacement Cycle
Customer Loyalty
Competitors capacity utilisation
Technological Know-how
Vertical Integration
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Companys Financial Strength
Return on Investment
Leverage
Liquidity
Capital Required / capital available
Cash Flow
Ease of exit from market
Risk involved in the business
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Industry Strength
Growth & Profit Potential
Financial Stability
Technological Know-how
Resource Utilisation
Capital Intensity
Ease of Entry into market
Productivity, Capacity Utilisation
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Environmental Stability
Technological Changes
Rate of Inflation
Demand Variability
Price range of competing products
Barriers to entry into market
Competitive pressure
Price Elasticity of Demand
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Scale of Assessment
For Companys Financial Strength and
Industry Strength, 0 to 7,with 0 reflecting
the most unfavourable assessment and 7the most favourable.
For Companys Competitive Advantage
and Environmental Stability ,0 to 7
,with0 reflecting the most favourable
assessment and 7 the most unfavourable
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Steps to Assessment
Plot the values on the four-dimensionalgraph
Average the numerical values to get thenumerical score for the dimension
Plot the scores for the four dimensions ofthe axes of the SPACE chart.
Connect the scores so plotted to get afour-sided polygon, reflecting the sizeand direction of the assessment.
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Strategic Postures
Aggressive Posture ( or Michael Porters OverallCost Leadership)
Competitive Posture ( or Michael PortersProduct Differentiation)
Conservative Posture( or Michael PortersFocus)
Defensive Posture ( or Michael PortersGamesmanship)
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Aggressive Posture
For companies which
enjoys competitive advantage
have considerable financial strength
belongs to an attractive industry, and
operates in a relatively stable environment
(Firm must fully exploit opportunities available to
it,look for acquisition possibilities, concentrateresources to maintain its competitive edge,and
enhance its market share.)
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Competitive Posture
For companies which enjoys competitive advantage
has limited financial strength
belongs to an attractive industry, and operates in a relatively unstable
environment
(Firm should enhance competitive advantage byproduct improvement and differentiation,widenthe product line,improve marketingeffectiveness and augment financial resources)
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Conservative Posture
For companies which
enjoys financial strength
has limited competitive advantage
belongs to a not-so-attractive industry,and operates in a relatively stable
environment
(Firm should prune non-performingproducts,reduce costs,improveproductivity,develop new products andaccess more profitable markets.)
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Defensive Posture
For companies which:
lacks competitive advantage
lacks Financial Strength belongs to a not-so-attractive industry,and
operates in a relatively stable environment
(Firm should discontinue unviable
products,control costs aggressively,monitor
cash flows strictly,reduce capacity and limit
investments.)
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Conglomerate Diversification
Diversification in Unrelated Areas.
Firms plan to increase their product lines.
They control a range of activities invarious industries that require different
skills in the specific managerial functions
of research, applied engineering,production, marketing and so on.
Can be achieved mainly by external
acquisition/merger
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Benefits of Con. Diversification
Reduces overall risk exposure and risk of
cyclicality
Expands opportunities for growth from
saturation to emerging industries in the life
cycle of the business.
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Cons of Conglo. Diversification
Reduces average profitability unrelated
diversification is not positively correlated
with profitability.
Organisations that stick very close to the
original business outperform others.
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Interface between Cap. Bud. and
Strategic Planning
Capital budgeting should be squarely
related to the corporate strategy
It should sub serve the strategy of the firm
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Investment Decisions under
Inflation Executives generally estimate cash flows
assuming unit costs and selling price prevailingin year zero to remain unchanged.
They argue that if there is inflation, prices can beincreased to cover increasing costs; therefore, theimpact on the projects profitability would be thesame if they assume rate of inflation to be zero.
This line of argument, although seems tobe convincing, is fallacious for tworeasons.
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Two Reasons
First, the discount rate used for discounting cash flowsis generally expressed in nominalterms. It would beinappropriate and inconsistent to use a nominal rate to
discount constant cash flows.
Second, selling prices and costs show differentdegrees of responsiveness to inflation:
The depreciation tax shield remains unaffected byinflation since depreciation is allowed on the bookvalue of an asset, irrespective of its replacement ormarket price, for tax purposes.
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What to do ?
We should be consistent in treatinginflation since the discount rate is marketdetermined it is stated in nominalterms.Thus the cash flows should also beexpressed in nominal terms.
In other words,cash flows should reflect effect ofinflation,when they are discounted by theinflation affected discount rate.
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Financing Effects in Investment
Evaluation According to the conventional capital budgeting
approach cash flows should not be adjusted for thefinancing effects.
The adjustment for the financing effect is made inthe discount rate. The firms weighted average costof capital (WACC) is used as the discount rate.
It is important to note that this approach of
adjusting for the finance effect is based on theassumptions that: The investment project has the same risk as the firm.
The investment project does not cause any change in the
firms target capital structure.
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Thanks