Course No.

ET ZC414

Project Appraisal
BITS Pilani
Hyderabad Campus

S. Hanumantharao
Session 2 Date : 1/11/2015

Total ppt :33

BITS Pilani
Hyderabad Campus

Chapter 2
Strategy and resource allocation

Objectives
1.
2.
3.
4.
5.
6.

How strategies are formulated.

Different types of strategies.
How conglomerates can add value.
Tools of portfolio planning.
How the corporate centre can add value.
Ways in which businesses compete.

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Introduction
If you look at any organization today what you see is mainly
the result of capital allocation decisions made in the past.
Its strategic assets, tangible or intangible, are traceable to the
investment decisions of yesteryears.
Companies generally elect one of three common strategic
postures -- shaping the future, adapting to the future or
reserving the right to play.
The resource allocation framework of the firm, which shapes,
guides, and circumscribes individual project decisions,
addresses two key issues

What should be the strategic posture of the firm ?

What pattern of resource allocation sub serves the chosen strategic
posture ?.

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Key criteria
The objective of maximizing the wealth of shareholders
is reflected, at the operational level, in three key criteria :
profitability, risk, and growth.
1. Profitability : Profitability reflects the relationship between
profit and investment. Profitability = Profit after tax/Net Worth.
2. Risk :- It reflects variability. How much do individual outcomes
deviate from the expected value ?
3. Growth :- This is manifested in the increase of revenue,
assets, net worth, profits, dividends, and so on. To reflect the
growth of a variable, the measure commonly employed is the
compound rate of growth.

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Formulation of Strategies

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Elementary Investment
Strategies
The building blocks of the corporate resource allocation
strategy are the following elementary investment
strategies :

Replacement and modernisation

Capacity expansion
Vertical integration
Concentric diversification
Conglomerate diversification
Divestment

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Overall or Grand Strategy

Growth

Stability

Concentr
ation

Vertical
Integration

Growth in market
size/product range or
mkt share

Backward or forward

Diversification
New Business

Contraction

Liquidation

Divesture
core competencies
and capabilities

Concentric
or related

manufacturing facilities
distribution network
ITC Hotels

Conglomerate
or unrelated

limited growth opportunities in the

existing line of business; emerging
and promising sectors, risk reduction
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Concentric Diversification
Enlarging the production portfolio by adding new
products with the aim of fully utilizing the potential of the
existing technologies and marketing system.
Growth through related diversification can create value
for shareholders, thanks to the following factors:
Managerial Economies of Scale diversification can utilize
managerial talent more effectively.
Higher Debt Capacity because of the coinsurance effect, a
diversified company has a higher debt capacity than a focused
company.
Lower Tax Burden by combining businesses that have
imperfectly correlated cash flows, a diversified firm can avail of
tax shelters better.

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Heterogeneous
(conglomerate) diversification
is moving to new products or services that have no
technological or commercial relation with current
products, equipment, distribution channels, but which
may appeal to new groups of customers.
The major motive behind this kind of diversification is the
high return on investments in the new industry.
Furthermore, the decision to go for this kind of
diversification can lead to additional opportunities
indirectly related to further developing the main company
business - access to new technologies, opportunities for
strategic partnerships, etc.

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BITS Pilani, Hyderabad Campus

Diversification : Good or Bad

Dampens average profitability

60s and 70s saw unrelated diversification
80s saw businesses divesting
90s back to diversification
Of course, diversification is not an unmixed blessing. It can lead to erosion of
shareholder value on account of the following:
Unprofitable Investment can destroy ready availability of surplus cash generated by some
businesses may tempt managers to invest in unprofitable (negative NPV) projects.
It expands opportunities for growth,
typically in emerging Industries
Though risky, has immense potential

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Portfolio Planning Tools

To guide the process of strategic planning and resource
allocation, several portfolio planning tools have been
developed. Two such tools highly relevant in this context
are :
BCG Product Portfolio Matrix
General Electrics Stoplight Matrix

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cash cows generate funds

and dogs, if divested, release
funds. On the other hand, stars
and question marks require
further commitment of funds.

Stars Product which enjoy a high, market

share and a high growth rate are
referred to as stars.
Question marks Products with high growth
potential but low present market
share are called question marks.
Cash Cows Products which enjoy a relatively
high market share but low growth
potential are called cash cows.
Dogs Products with low markets share and
limited growth potential are referred
to as dogs.

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General Electric's Stoplight Matrix

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BITS Pilani, Hyderabad Campus

Parenting Advantage

Classic approach to business portfolio management, as

exemplified by the BCG matrix and the McKinsey
matrix, focuses on the overall attractiveness of the
industry and the
business's competitive position
within the industry.
While the classic approach is inherently sound, it suffers
from a limitation. It ignores the synergies between
different businesses in the firm's portfolio and assumes
that the firm is the right owner for all its businesses.
Since different skills are required for managing different
businesses, it is necessary to go beyond business
positioning and consider whether there is a good fit
between the parent and the business unit.
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Parenting Advantage
1.

Synergies between different businesses in the firm's

portfolio
2. A natural parent, compared to other possible owners, can
extract more value. Parenting advantage stems from certain
core competencies.
3. Most companies have a few core competencies (such as
project management, cost management, product
development, manufacturing excellence, brand
management, performance management, human resources
management, and so on).
4. A core competency represents a world class skill or process
that gives the company an edge over competitors, creates
value, and is durable.

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McKinsey and Company recommends a more sophisticated approach to

business portfolio management that considers parenting advantage along
with the business unit's inherent value creation potential.
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How the Corporate Centre Can Add Value

The corporate centre in a multi business 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 .

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Effectiveness of Portfolio
Management
Corporate portfolio management is mainly concerned with
deciding which businesses to own and which businesses to
divest.
Measurement and Information Problems: In theory a firm
should exit a business when the expected rate of return from
continuing the business is less than the cost of capital.
Behavioral factors: Implementation of effective portfolio
management practices is hampered by "sunk cost thinking",
"loss aversion," "endowment, "status quo bias."
Sunk costs are not relevant for decision making. Yet people do
not overlook sunk costs.

Corporate Governance and Incentives: management is

different from shareholders

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Business level strategies

1. Diversified firms don't compete at the corporate level. Rather, a
business unit of one firm competes with a business unit of another.
2. Among the various models that can be used as frameworks for
developing a business level strategy, the Porter's generic model is
perhaps the most popular.
3. There are three generic strategies that can be adopted at the
business unit level: cost leadership, differentiation, and focus.
4. Another strategy that has gained recognition in recent times is the
network effect strategy.
5. A strategy of focus involves concentrating on a narrow line of
products or a limited market segment. In the selected target market
the company seeks to gain a competitive edge through cost
leadership (cost focus) or product differentiation (differentiation
focus).
A strategy of differentiation focus involves concentrating on a
limited market segment wherein the firm can offer a differentiated
product based on its innovative capabilities.

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BITS Pilani, Hyderabad Campus

Network Effect Strategy

Telephones, first introduced in the US in late 19th

century, were not very useful initially.
A person could just talk to few others who had a
telephone.
But as more and more homes and offices joined the
telephone network, the utility of telephones increased.
This phenomenon referred to as the network effect: the
value of a product or service increases as more and
more people use it.
Success with the network strategy depends on the
ability of a company to lead the charge and establish a
dominant position.

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Competitive advantage or
value creation

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Achieving and Sustaining

Competitive Advantage
A firm does not achieve and sustain competitive
advantage by merely choosing a competitive strategy.
It has to make necessary commitments to develop the
required core competencies and structure its value chain
efficiently.
Core competencies are the key economic assets or
resources of the firm and value chain is the linked set of
activities performed to transform inputs into outputs.
The uniqueness of firm's core competencies and its
value chain and the extent to which it is difficult for
competitors to imitate them determines the sustainability
of a firm's competitive advantage.

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Value Chain

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Real investment decisions are not made in a

vacuum; they are embedded in a companys
strategy

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Interactions between Financing

and Investment Decisions
Because rms are usually nancially constrained, they
must coordinate their investment strategies with their
nancing policies.
The synchronization of investment opportunities and
access to funds for investment is the key goal of modern
corporate risk management.
Financially strong rms overinvest in capacity and adopt
aggressive competitive strategies to drive nancially
weak companies out of the market.

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Summary
Capital budgeting is not the exclusive domain of financial
analysts and accountants.
Rather, it is a multifunctional task linked to a firm's overall
strategy .
Capital budgeting may be viewed as a two-stage process.
In the first stage promising growth opportunities are
identified through the use of strategic planning
techniques and in the second stage individual
investment proposals are analyzed and evaluated in
detail to determine their worth whileness.
Strategy involves matching a firm's capabilities to the
opportunities in the external environment.

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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.

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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 strategic planning and
resource allocation. Three such tools are the BCG matrix, the
General Electric's stoplight matrix, and the McKinsey matrix.
Diversified firms don't compete at the corporate level. Rather, a
business unit of one competes with a business unit of another.
Among the various models that can be used as frameworks for
developing a business level strategy, the Porter's 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 sub
serve the strategy of the firm. Hence, the relationship between
strategic planning and capital budgeting must be properly
recognized.

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THANKYOU

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