PROJECT APPRAISAL PLANNING AND CONTROL

1. CHAPTER 2
STRATEGY AND CAPITAL
ALLOCATION

2.  Concept of strategy
 Grand strategy
 Diversification debate
 Portfolio strategy
 Business level strategy
 Strategic planning and capital budgeting
OUTLINE

3. Concept of Strategy
 Chandler defined strategy as “the determination of the basic long-
term goals and objectives of an enterprise, and the adoption of
courses of action and the allocation of resources necessary for
carrying out the goals.”
 Strategy involves matching a firm’s ‘strengths’ and ‘weaknesses’
with the ‘opportunities’ and ‘threats’ present in the external
environment.

4. Formulation of Strategies
Environmental Analysis
Customers
Competitors
Suppliers
Regulation
Infrastructure
Social/political
environment
Internal Analysis
Technical know-how
Manufacturing capacity
Marketing and
distribution capability
Logistics
Financial resources
Opportunities and threats
Identify opportunities
Strengths and weaknesses
Determine core capabilities
Find the fit between
core capabilities and
external opportunities
Firm’s strategies

5. Diversification
Grand
Strategy
Growth ContractionStability
Concentration Vertical
integration
Liquidation Divestiture
The Thrust of Grand Strategy

6. Strategies, Principal Motivations, and Likely Outcomes
Principal Likely Outcomes
Strategy Motivations Profitability Growth Risk
 Concentration - Ability to serve a High Moderate Moderate
growing market
- Familiarity with technology
and market
- Cost leadership
 Vertical integration - Greater stability for existing High Moderate Moderate
and proposed operations
- Greater market power
 Concentric - Improves utilisation of High Moderate Moderate
diversification resources
 Conglomerate - Limited scope in the present Moderate High Low
diversification business
 Stability - Satisfaction with status quo High Low Low
 Divestment - Inadequate profit High Low Low
- Poor strategy

7. A
B
(A+B)
ROI
Diversification Debate
Pros and Cons
 Reduces overall risk exposure
 Expands opportunities for growth
 Dampens profitability
Diversification and Risk Reduction

8. Why Conglomerates Can Add Value in Emerging
Markets
Khanna and Palepu believe that while focus makes eminent sense in the
west, conglomerates have certain advantages in emerging markets
which are characterised by institutional weaknesses in the following
areas :
 Product markets
 Capital markets
 Labour markets
 Regulation
 Contract enforcement

9. Diversification and Value Creation
Market Failure Form of
Diversification
Source of Value
Addition
Capital markets Unrelated
diversification
Governance
economies
Product markets Vertical integration Coordination
economies
Resource markets Related diversification Scope economies
Risk markets Strategic
diversification
Option economies

10. Diversification – A Mixed Bag
Positives Negatives
 Managerial economies of
scale
 Dissipation of managerial
focus
 Higher debt capacity  Unprofitable investment.
 Lower tax burden
 Larger internal capital

11. Compulsions for Conglomerate Diversification in India
 Restriction in growth in the existing line of business, often arising from governmental
refusal to expansion proposals.
 Vulnerability to changes in governmental policies with respect to imports, duties,
pricing, and reservations.
 Opening up of newer areas of investments in the wake of liberalisation.
 Cyclicality of the main line of business leading to wide fluctuations in sales and profits
from year to year.
 Bandwagon mentality which has been induced by years of close regulation of
industrial activity.
 Desire to avail of tax incentives mainly in the form of investment allowance and large
initial depreciation write-offs.
 A self-image of venturesomeness and versatility prodding companies to prove
themselves in newer fields.
 A need to widen future options by entering newly emerging industries where the
potential seems enormous.

12. How to Reduce the Risks in Diversification
Markides argues that the risk of diversification can be mitigated if
managers address the following questions:
 What can our company do better than any of its competitors in its
current market?
 What strategic assets do we need in order to succeed in the new
market?
 Can we catch up to or leapfrog competitors at their own game?
 Will diversification break up strategic assets that need to be kept
together?
 Will we simply be a player in the new market or will we emerge a
winner?
What can our company learn by diversifying and are we sufficiently
organised to learn it?

13. Guidelines for Conglomerate Diversification
1. If you lack financial sinews to sustain the new project during the ‘learning period’,
avoid grandiose diversification projects.
2. Realistically examine whether you have the critical skills and resources to succeed
in the new line of business.
3. Ensure that the diversification project has a good fit in terms of technology and
market with the existing business.
4. Try to be the first or a very early entrant in the field you are diversifying into. This
will protect you from serious competitive threat in the initial years.
5. Where possible adopt the following sequence: marketing – substantial sub-
contracting – full blown manufacturing.
6. Seek partnership of other firms in areas where you are vulnerable or competitively
weak.
7. If the failure of the new project can threaten the company’s existence, float a
separate company to handle the new project.
8. Remember that meaningful conglomerate diversification represents the greatest
challenge to corporate vision and leadership.
9. Guard against bandwagon mentality and empire-building tendencies.

14. Portfolio Strategy
In a multi-business firm, allocation of resources across various
businesses is a key strategic decision. Portfolio planning tools have been
developed to guide the process of strategic planning and resource
allocation. Three such tools are the BCG matrix, the General Electric’s
stoplight matrix, and the Mckinsey matrix.

15. BCG Matrix
High Low
Low
High
M
a
r
k
e
t
G
r
o
w
t
h
R
a
t
e
Stars
Question
Marks
Cash
Cows
Dogs
Market Share

16. Pattern of Capital Allocation
Stars Question marks
Cash cows Dogs on divestment
(funds generated) (funds released)
Stars Question marks
1
Cash cows Dogs
Part A
Part B

17. General Electric’s Stoplight Matrix
Business Strength
H
i
g
h
M
e
d
i
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m
L
o
w
A
t
t
r
a
c
t
i
v
e
n
e
s
s
I
n
d
u
s
t
r
y
Invest
Invest Hold
DivestHold
Invest Hold
Divest
Divest
Strong Average Weak

18. McKinsey Matrix
Very similar to the General Electric Matrix, the McKinsey matrix has two dimensions,
viz competitive position and industry attractiveness. The criteria or factors used for
judging industry attractiveness and competitive position along with suggested weights
for them are as follows:
Industry Attractiveness Competitive Position
Criteria Weight Key Success Factors Weight
Industry size 0.10 Market share 0.15
Industry growth 0.30 Technological know how 0.25
Industry profitability 0.20 Product quality 0.15
Capital intensity 0.05 After-sales service 0.20
Technological stability 0.10 Price competitiveness 0.05
Competitive intensity 0.20 Low operating costs 0.10
Cyclicality 0.05 Productivity 0.10

19. Assessment of the SBU Factory Automation
Industry Attractiveness
Criteria Weight Rating Weighted Score
Industry size 0.10 4 0.40
Industry growth 0.30 4 1.20
Industry profitability 0.20 3 0.60
Capital intensity 0.05 2 0.10
Technological stability 0.10 2 0.10
Competitive intensity 0.20 3 0.60
Cyclicality 0.05 2
Competitive Position
Key Success Factors Weight Rating Weight Score
Market share 0.15 4 0.60
Technological know how 0.25 5 1.25
Product quality 0.15 4 0.60
After-sales service 0.20 3 0.60
Price competitiveness 0.05 4 0.20
Low operating costs 0.10 4 0.40
Productivity 0.10 5
0.10
3.10
0.50
4.15

20. A
t
t
r
a
c
t
i
v
e
n
e
s
s
Good Medium Poor
High Winner Winner Question Mark
Medium Winner Average Business Loser
Low Profit Producer Loser Loser
I
n
d
u
s
t
r
y
The McKinsey Matrix
Competitive Position

21. Market-Activated Corporate Strategy (MACS) Framework
Source: McKinsey & Company

22. How the Corporate Centre Can Add Value*
According to Tom Copeland, Tim Koller, and Jack Murrin, the corporate centre in a
multibusiness company or group can add value in the following ways:
Industry shaper It acts proactively to shape an emerging industry to its advantage.
Deal Maker It spots and executes deals based on its superior insights.
Scarce Asset Allocator It allocates capital and other resources efficiently across different
businesses.
Skill Replicator It facilitates the lateral transfer of distinctive resources.
Performance Manager It instills a high performance ethic with appropriate measurement
systems and incentive structures.
Talent Agency It attracts, retains, and develops talent.
Growth Asset Allocator It leads innovation in multiple businesses.
* Adapted from Tom Copeland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the
Value of Companies, New York: John Wiley and Sons, 2000, P.94

23. Portfolio Configuration
 Identifying the appropriate configuration of business portfolio is
perhaps the most important task of top management. It calls for
an insightful assessment of the logic of relatedness among
various businesses in the portfolio.
 According to C.K. Prahalad and Yves Doz there are different
ways of thinking about relatedness:
 Business selection
 Parenting similarities
 Core competencies
 Interbusiness linkages
 Complex strategic integration

24. Barriers to Effective Corporate
Portfolio Management - 1
 Corporate portfolio management perhaps has the greatest impact on
value creation.
 Despite its significance, many companies do not manage their
business portfolios optimal.
 Three major barriers to effective corporate portfolio management
are:
• Measurement and information problems
• Behavioural factors
• Corporate governance and incentives

25. Barriers to Effective Corporate Portfolio Management - 2
 Measurement and information problems
 Assuming that the growth pattern of a business is an “S” curve, the slope at any
point of the “S” curve may be regarded as a proxy for the expected return from that
point on.
 The practical problem, of course, is that it is very difficult to establish that you are
at an inflexion point.
 Behavioural Factors
 Sunk cost thinking
 Loss aversion
 Endowment effect
 Status quo bias
 Corporate governance and incentives
 Despite understanding the logic of shareholder wealth maximisation, many
corporate boards and senior managements commit to other objectives.

26. Enhancing the Effectiveness of Corporate Portfolio
Management
1. Create a team of independent people for portfolio review.
2. Improve the quality of information.
3. Develop processes for thinking about alternatives.
4. Look outside the company.

27. Business Level Strategies
 Diversified firm’s don’t compete at the corporate level. Rather, a
business unit of one firm competes with a business unit of another.
 Among the various models that have been used as frameworks for
developing a business level strategy, the Porter’s generic model is
perhaps the most popular
 According to Porter, there are three generic strategies that can be
adopted at the business unit level.
 Cost leadership
 Differentiation
 Focus

28. Strategy of Cost Leadership:
Dell Computer Corporation
• Direct selling
• Built-to-order manufacturing
• Low cost service
• Negative working capital

29. Sources of Competitive Advantage:
Unique Value as Lowest Cost
Perceived by
Customer
Broad
(industry-wide)
Strategic Scope
Narrow
(segment only)
Overall Overall Cost
Differentiation Leadership
Focused Focused Cost
Differentiation Leadership
Porter’s Generic Competitive Strategies

30. Network Effect Strategy
 Network effect: The value of a product or service increases as more and
more people use it.
 Network strategy: Success with the network strategy depends on the ability
of a company to lead the charge and establish a dominant position.
• eBay
• Microsoft
 Richard Luecke: “Thus since, most PCs operated with Windows, most new
software was developed for Windows machines. And because most software
was Windows-based, more people bought PCs equipped with the Windows
operating system. To date no one has broken this virtuous circle.”

31. Environmental
assessment
Managerial vision,
values, and attitudes
Corporate
appraisal
Strategic plan
Capital
budgeting
Product strategy,
market strategy,
production strategy,
and so on
Strategic Planning and Capital Budgeting

32. COST
LEADERSHIP
Aggressive
FOCUS
Conservative
Defensive
GAMESMAN-
SHIP
Competitive
DIFFEREN-
TIATION
FS
ES
CA IS
Concentric Diversification
Concentration
Vertical
Integration
Concentric
Merger
Conglomerate Merger
Turnaround
Status Quo
Conglomerate
Diversification
Diversification
Divestment
Liquidation
Retrenchment
Generic Strategies and Key Options

33. 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 analysed
and evaluated in detail to determine their worthwhileness.
 Strategy involves matching a firm’s “strengths” and “weaknesses” – its distinctive
competencies with the “opportunities” and “threats” present in the external
environment.
 The thrust of the overall strategy or ‘grand strategy’ of the firm may be on growth,
stability, or contraction.
 Generally, companies strive for growth in revenues, assets, and profits. The
important growth strategies are concentration, vertical integration, and
diversification.
 While growth strategies are most commonly pursued, occasionally firms may
pursue a stability strategy.

34.  Contraction is the opposite of growth. It may be effected through divestiture or
liquidation.
 Conglomerate diversification, or diversification into unrelated areas, is a very
popular but highly controversial investment strategy. Although a good device for
reducing risk exposure and widening growth possibilities, conglomerate
diversification more often than not tends to dampen average profitability.
 In western economies, corporate strategists have argued from the 1980s that the
days of conglomerates are over and have preached the virtues of core competence
and focus. Many conglomerates created in the 1960s and 1970s have been
dismantled and restructured. Tarun Khanna and Krishna Palepu, however, believe
that while focus makes eminent sense in the west, conglomerates may have certain
advantages in emerging markets which are characterised by many institutional
shortcomings.
 In a multi-business firm, allocation of resources across various businesses is a key
strategic decision. Portfolio planning tools have been developed to guide the
process of strategic planning and resource allocation. Three such tools are the
BCG matrix, the General Electric’s stoplight matrix , and the Mckinsey matrix.

35.  Diversified firms don’t compete at the corporate level. Rather, a business unit of
one firm competes with a business unit of another. Among the various models that
can be used as frameworks for developing a business level strategy, the 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 subserve the
strategy of the firm. Hence, the relationship between strategic planning and capital
budgeting must be properly recognised.