Strategic Management

1. Strategic Management and Firm Performance Chapter Two © 2006 by Nelson, a division of Thomson Canada Limited.

2. The Strategic Management Process Strategic  Actions  Ch. 1: Strat. Mgmt. & Com-petitiveness Chapter 3: The External Environment Chapter 4: The Internal Environment Strategic Competitiveness Strategic Mission & Strategic Intent Strategic Objectives & Inputs Chapter 1: Strategic Management Ch. 2: Strat. Mgmt . & Performance Ch. 2: Strat. Mgmt . & Performance Chapter 5: Bus.-Level Strategy Chapter 6: Competitive Dynamics Chapter 7: Corp.-Level Strategy Chapter 8: Acquisition & Restructuring Chapter 9: International Strategy Chapter 10: Cooperative Strategy Strategy Formulation Chapter 11: Corporate Governance Ch. 12: Org. Structure & Controls Chapter 13: Strategic Leadership Chapter 14: Org. Renewal & Innovation Strategy Implementation Strategic Competitiveness

6. Levels of Performance When the actual value created is greater than the expected value Above-normal Occurs when the actual value created is equal to the expected value Normal performance When the actual value created is less than the value owners expectations Below-normal

9. Approaches to Firm Performance 1. Firm Survival 3. Multiple Stakeholder Approach 4. Present Value 5. Market-based Measures 6. Market Value Added / Economic Value Added 7. The Balanced Scorecard 8. Corporate social responsibility 2. Accounting Measures

10. Firm Survival & Firm Performance Altman’s Z = Total Assets Working Capital * 0 + .033 + .006 .012 + .014 + .100 Earnings Before Interest & Taxes Total Assets Market Value of Firm Equity Book Value of Firm Debt Retained Earnings Total Assets Sales Total Assets

11. Firm Survival & Firm Performance Altman’s Z * 0 - 0 1.8 3.2 10 Likely to Survive Grey Area Likely to fail

13. Profitability Ratios 1 / 2 Accounting Measures & Firm Performance Measures the revenue left to cover operating expenses after taking out the cost of procurement Assesses firm profitability without regard to interest charges as a result of the capital structure After tax profits per dollar of sales 0 Gross Profit Margin Operating Profit Margin Net Profit Margin (Return on Sales) Ratio Calculation What the Ratio Means Sales–Cost of goods sold Sales Profit before interest & taxes Sales Profits after taxes Sales

14. Profitability Ratios 2 / 2 Measures the return on the total investment in the firm Return on investment common shareholders have made in the firm Profit after taxes (PAT) Total shareholders’ equity Rate of return to share-holders given their investment in the firm Earnings available to common shareholders Accounting Measures & Firm Performance 0 Return on Total Assets R eturn on shareholders equity Return on common equity Earnings per share PAT–Preferred stock dividends Total shareholders’ equity Profit after taxes+interest Total assets PAT–Preferred stock dividends # common shares outstanding Ratio Calculation What the Ratio Means

15. Liquidity Ratios Ability to cover ST debt with assets convertible to cash in the period ST debt matures Current ratio Quick ratio (Acid-Test Ratio) Inventory to net working capital Ability to pay off short-term debt without relying on inventory Measure to which firm’s working capital is tied up in inventory Accounting Measures & Firm Performance * Current Assets Current Liabilities Inventory Current assets-current liabilities Current assets-Inventory Current liabilities Ratio Calculation What the Ratio Means

16. Leverage Ratios 1 / 2 Measures use of debt to finance operations Debt-to-assets ratio Debt-to-equity ratio Long-term debt to equity ratio Balance between debt & equity in long-term capital structure of firm Use of debt relative to shareholders’ investment in firm Accounting Measures & Firm Performance Total debt Total assets Total debt Total shareholders equity Ratio Calculation What the Ratio Means Long-term debt Total shareholders equity

17. Leverage Ratios 2 / 2 Measures how much profits can decline before firm is unable to meet its interest obligations Times interest earned Fixed- charge coverage More inclusive measure of ability of firm to handle all of fixed-charge obligations Accounting Measures & Firm Performance Profits before interest & taxes Total interest charges Profits before interest & taxes + Lease obligations Interest charges + Lease obligations Ratio Calculation What the Ratio Means

18. Misc. Ratios - Shareholder Returns Measures return to common shareholders Dividend yield on common stock Price/Earning ratio Dividend payout ratio Market perception of firm Faster-growing / less risky firms tend to have higher P/E ratios Accounting Measures & Firm Performance Indicates dividends paid out as a % of profits Annual dividends per share After-tax earnings per share Current market price per share After-tax earnings per share Annual dividends per share Current market price per share Ratio Calculation What the Ratio Means

19. Miscellaneous Ratios Measures total cash per share available to firm Cash Flow per Share Break-even analysis Measures the number of units that need to be sold to begin to make a profit on that product or service Accounting Measures & Firm Performance Contribution margin = (Selling price/unit) – (variable price/unit) After-tax profits+depreciation # of common shares outstanding Fixed costs Contribution margin Ratio Calculation What the Ratio Means

20. Accounting Measures & Firm Performance + Easily available for publicly traded firms + Stock exchanges stress quality accounting data . as a tool for investor decisions + Broad support for use as a performance measure + May provide insights to economic rates of return However, they - May have a built in short‑term bias - Are subject to manipulation by managers - Undervalue intangible assets $ $ $ Accounting Measures are Popular in Analysis

21. Multiple Stakeholder Approach & Firm Performance (The firm must maintain performance at an adequate level in order to maintain the participation of key groups affected by the firm.) Firm Capital Market Stock market/Investors Debt suppliers/Banks Product Market Primary Customers Suppliers Organizational Employees Managers Non-Managers The trouble is that each group seldom has the same goals in mind

22. Present Value & Firm Performance Avoid short-term bias by measuring cash flows over time. Value all resources made available to a firm by using the discount rate concept. (Estimate net cash flows and expected discount rates for several years into the future.) Allow assessment of firm and/or project’s performance on a forward-looking basis. Net Present Value < 0 Below average returns Net Present Value = 0 Average returns Net Present Value > 0 Above average returns

23. Present Value & Firm Performance + Close link between present value & the conceptual definition of performance . Strengths + Positive net present-value strategies should maximize the wealth of shareholders In doing so they will likely generate enough cash to satisfy other stakeholders + s

24. Present Value & Firm Performance - Misjudging prediction of cash flow patterns several years into the future . Weaknesses - Cash flows on projects worth billions & lasting decades may be a problem. - Hard to assess the firm’s systematic risk. - (Beta) & such risk may change over time. But, researchers question the adequacy of the economic model on which the beta estimation is based. (Capital Asset Pricing Model: CAPM) - s - Measuring the discount rate is a problem.

25. Present Value & Firm Performance The use of net present-value (NPV) must be done with it’s limitations in mind. But using Present Value may allow for a deeper understanding of firm performance.

26. Stock Market measures Market - Based Measures & Firm Performance in essence: S * - RFR * a + b ( M – RFR * ) + e % change in stock price * – Risk free rate of return * = = * For 250 trading days Risk-free rate of return for firm’s stock + Systematic risk in the stock market [Beta] X % change in daily Risk free rate closing value of the - of return * stock market index * . + Residual obtained when estimating risk free rate and systematic risk

29. Market - Based Measures & Firm Performance + These measures may more accurately reflect econ. performance than accounting based measures. . . Useful for assessing econ. value of a given strategy or . choosing between strategies that could be implemented. + s + Market-based measures focus on the present value of future streams of income, (e.g., expected value of future cash flows) not past performance. 0 Strategy researchers have increasingly relied on market-based measures of firm performance. This increased use may partially be a response to the criticisms of accounting-based measures. +

30. Market - Based Measures & Firm Performance - s 0 These measures were not originally designed for measurement of firm performance but portfolios. - Sharpe’s & Treynor’s measures implicitly use the risk-free rate as cost of capital & is thus a problem when assessing smaller firms. - Treynor Measure assumes unsystematic risk is fully diversified away. While appropriate for investment portfolios it may not be so for firms. - The need to use Market indexes like the TSE300 means heavily weighted firms like Nortel Networks over-influence the index. -

31. Market - Based Measures & Firm Performance This suggests that market measures tell us something different about performance than accounting measures. 0 Although the four measures have limitations, they provide insight into the ability of a firm to achieve above-average returns, average returns or below-average returns. ! Correlations between the accounting measures & market measures are only 0.15 to 0.30. !

32. Market Value Added (MVA) is: The difference between the cash investors expect to receive given the firm’s current market value and the amount of cash that debt & equity holders have invested in the firm since inception. $75 billion Current total market value of the firm - $20 billion Given by firm debt holders - $15 billion Given by firm equity holders - $30 billion Retained from operations Market Value Added / Economic Value Added & Firm Performance $10 billion MVA

33. Economic Value Added (EVA) is: An internal measure of a firm’s ability to generate MVA in the future. Market Value Added / Economic Value Added & Firm Performance The amount of operating capital at the beginning of each year times the difference between the rate of return on capital & the weighted average cost of the debt & equity capital employed. The present value of all projected EVAs = MVA

34. Economic Value Added (EVA) To create shareholder value, any or all of these will increase EVA: Market Value Added / Economic Value Added & Firm Performance 1. Improve return on capital already employed. (generate more profits without employing more capital) 2. Invest more capital in strategies having a greater rate of return than the cost of the capital employed. 3. Withdraw capital from strategies/projects having a cost of capital greater than their rate of return.

35. The 2003 Stern Stewart 1000 MVA Rating © 2003 Stern Stewart 7.8% 307.0% 6 (2,174) 84,379 Exxon Mobil Corp 10 8 8.7% 19.1% 5 3,872 103,664 Merck & Co 11 5 9.0% 15.0% 14 2,839 116,396 Johnson & Johnson 7 4 8.8% 13.0% 17 2,935 182,769 Wal-Mart Stores 3 3 8.1% 14.5% 1 5,946 183,386 General Electric Co. 2 2 CoC ‘02 ROC ‘02 1997 EVA ‘02 MVA ‘02 Company name 2001 2002 13.6% 17.7% 2 1,076 219,165 Microsoft Corp. 1 1 6.9% 17.5% 4 2,446 92,015 Coca Cola Co. 13 6 8.0% 13.0% 9 1,925 89,722 Procter & Gamble 16 7 11.6% 9% 18 (8,032) 75,175 Intl. Business Machines 5 9 10.3% 9% - 2,964 68,078 Citigroup 6 10 10.4% 4.8% 34 (8,695) (25,862) SBC Communications 72 996 14.1% -12.8% 487 (10,902) (36,006) JDS Uniphase Corp. 999 997 10.1% -22.1% 30 (20,802) (37,218) Lucent Technologies 1000 998 9.5% -8.7% 28 (28,484) (64,071) A T & T Corp. 998 999 9.4 -8.0% 99 (32,747) (83,005) A O L Time Warner Inc. 997 1000

36. Market Value Added / Economic Value Added & Firm Performance MVA is considered an estimate of the NPV of all the firm’s capital projects, both ongoing & anticipated by investors. + s MVA - a good measure of shareholder wealth creation or destruction that also captures the ability of the firm’s senior leaders to manage the firm’s capital. + + Positive EVA/MVAs suggest that firms are maximizing shareholder wealth and that these firms are efficiently allocating the resources flowing to them. + Changes over time should be examined closely by a firm’s stakeholders. This may be a more effective measure than absolute EVA/MVA at one point in time.

37. Market Value Added / Economic Value Added & Firm Performance - s EVA does not assess econ. profit (the difference in econ. value at 2 points in time) but accounting income. - There is a lack of consistent definitions for EVA, capital, and net operating profit after taxes. - EVA is too complex, requiring 160 adjustments under Generally Accepted Accounting Principles. - EVA is an inadequate single measure for decisions in that it only measures short-term profitability. - Given EVA is a short-term measure, it may be wrong to reward managers based only on EVA. - EVA is not appropriate for capital budgeting. -

38. Market Value Added / Economic Value Added & Firm Performance MVA/EVA is easy for managers to manipulate and it may create undesirable impacts: - s EVA requires capitalization of R&D even if such expenditures may have no future value. - Managers could develop a short-term bias. - Managers could decide to spend little or no time on quality improvement. - EVA permits capitalization of restructuring charges & may lead to unnecessary restructuring. - EVA permits the holding back of expenditures as assets even if they have no future value. -

39. Market Value Added / Economic Value Added & Firm Performance Less than 20 adjustments may be needed but which 20 will vary between each firm and be based on the industry in which it operates. An educated approach to the required 160 adjustments is needed.

40. Market Value Added / Economic Value Added & Firm Performance Assessing future direction of a firm’s EVA & knowing its value-creating / destroying capabilities allows one to derive likely scenarios for future stock prices. EVA methodology, applied appropriately, may be very valuable in unveiling hidden investment opportunities & over-valued projects and strategies.

45. The Strategic Management Process Strategic  Actions  Chapter 3: The External Environment Chapter 4: The Internal Environment Strategic Competitiveness Strategic Mission & Strategic Intent Strategic Objectives & Inputs Chapter 1: Strategic Management Ch. 2: Strat. Mgmt . & Performance Ch. 2: Strat. Mgmt . & Performance Chapter 5: Bus.-Level Strategy Chapter 6: Competitive Dynamics Chapter 7: Corp.-Level Strategy Chapter 8: Acquisition & Restructuring Chapter 9: International Strategy Chapter 10: Cooperative Strategy Strategy Formulation Chapter 11: Corporate Governance Ch. 12: Org. Structure & Controls Chapter 13: Strategic Leadership Chapter 14: Org. Renewal & Innovation Strategy Implementation Strategic Competitiveness