Finance Theory and Financial StrategySTEWART C . MYERS                                       Sloan School of Management   ...
FINANCE THEORYproperly applied.                                        equivalent in risk to the project   The first task ...
MYERSrate.                                          planning as "capital budgefing on a grand   Finance theory stresses ca...
FINANCE THEORYthe same major project. When low net               ning seems extremely naive from a finan-present value pro...
MYERSworld, and that financial analysis diverts     standard discounted cash flow analyses ofattention from, and sometimes...
FINANCE THEORY    The trouble is that strategic analyses are    often misapplied. It may be an attempt to also subject to ...
MYERScash flows are not fully adjusted for fu-       are worked out for anticipated challenges.ture inflation. Thus accele...
FINANCE THEORY accept its verdict on how well the firm is       mission the Gallup Poll to extract proba- doing.          ...
MYERS   It should be possible to provide a better   second-stage must depend on the first: ifframework for forecasting ope...
FINANCE THEORY    stretched to say that Apple Com-              (4) DCF is no help at all for pure research    puters stoc...
MYERSThe time-series links between projects are       gibles is not ignored by good managersthe most important part of fin...
FINANCE THEORYReferences Alberts, W. A. and McTaggart, James M. 1984,    "Value based strategic investment planning,"    I...
Finance theory and financial strategy
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Finance theory and financial strategy

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Finance theory and financial strategy

  1. 1. Finance Theory and Financial StrategySTEWART C . MYERS Sloan School of Management Massachusetts Institute of Technology Cambridge, Massachusetts 02139Despite its major advances, finance theory has had scant im-pact on strategic planning. Strategic planning needs financeand should learn to apply finance theory correctly. Hov^ever,finance theory must be extended in order to reconcile financialand strategic analysis.S trategic planning is many things, but (1) Finance theory and traditional ap- it surely includes the process of de-ciding how to commit the firms resources proaches to strategic planning may be kept apart by differences in languageacross lines of business. The financial side and "culture."of strategic planning allocates a particular (2) Discounted cash flow analysis mayresource, capital. have been misused, and consequently Finance theory has made major ad- not accepted, in strategic applications.vances in understanding how capital (3) Discounted cash flow analysis may failmarkets work and how risky real and fi- in strategic applications even if it isnancial assets are valued. Tools derived properly applied.from finance theory, particularly dis- Each of these explanations is partly true. Icounted cash-flow analysis, are widely do not claim that the three, taken to-used. Yet finance theory has had scant gether, add up to the whole truth. Never-impact on strategic planning. theless, I will describe both the problems I attempt here to explain the gap encountered in applying finance theory tobetween finance theory and strategic strategic planning, and the potentialplanning. Three explanations are offered: payoffs if the theory can be extended andCopyright © 1984, The Institute of Management Sdences PLANNING — CORPORATE0092-2102/84/140i;0126$01.25 FINANCE — CORPORATE FINANCEINTERFACES 14: 1 January-February 1984 (pp. 126-137)
  2. 2. FINANCE THEORYproperly applied. equivalent in risk to the project The first task is to explain what is being valued.meant by "finance theory" and the gap equals PV less the cash outlay re-between it and strategic planning. quired at t = 0.The Relevant Theory Since present values add, the value of The financial concepts most relevant to the firm should equal the sum of the val-strategic planning are those dealing with ues of all its mini-firms. If the DCF for-firms capital investment decisions, and mula works for each project separately, itthey are sketched here at the minimum should work for any collection of projects,level of detail necessary to define "finance a line of business, or the firm as a whole.theory." A firm or line of business consists of in- Think of each investment project as a tangible as well as tangible assets, andmini-firm, all-equity financed. Suppose growth opportunifies as well as assets-its stock could be actively traded. If we in-place. Intangible assets and growthknow what the mini-firms stock would opportunities are clearly refiected in stocksell for, we know its present value, and prices, and in principle can also be valuedtherefore the projects present value. We in capital budgeting. Projects bringing in-calculate net present value (NPV) by sub- tangible assets or growth opportunities totracting the required investment. the firm have correspondingly higher In other words, we calculate each proj- NPVs. I will discuss whether DCF for-ects present value to investors who have mulas can capture this extra value later.free access to capital markets. We should The opportunity cost of capital variestherefore use the valuation model which from project to project, depending onbest explains the prices of similar securi-risk. In principle, each project has its ownties. However, the theory is usually boiledcost of capital. In practice, firms simplifydown to a single model, discounted cash by grouping similar projects in riskfiow (DCF): classes, and use the same cost of capital for all projects in a class. The opportunity cost of capital for a line of business, or for the firm, is a value- weighted average of the opportunity costswhere PV = present (market) value; of capital for the projects it comprises. Ct = forecasted incremental cash flow The opportunity cost of capital depends after corporate taxes — strictly on the use of funds, not on the source. In speaking the mean of the distribu- most cases, financing has a second-order tion of possible C/s; impact on value: You can make much T = project life (Cr includes any sal- more money through smart investment vage value); decisions than smart financing decisions. r = the opportunity cost of capital, The advantage, if any, of departing from defined as the equilibrium ex- all-equity financing is typically adjusted pected rate of return on securities for through a somewhat lowered discountJanuary-February 1984 127
  3. 3. MYERSrate. planning as "capital budgefing on a grand Finance theory stresses cash fiow and scale," because capital budgeting in prac-the expected return on compefing assets. tice is a bottom-up process. The aim is toThe firms investment opportunities com- find and undertake specific assets or proj-pete with securifies stockholders can buy. ects that are worth more than they cost.Investors willingly invest, or reinvest, Picking valuable pieces does not insurecash in the firm only if it can do better, maximum value for the whole. Piecemeal,risk considered, than the investors can do bottom-up capital budgeting is noton their own. strategic planning. Finance theory thus stresses fundamen- Capital budgeting techniques, however,tals. It should not be deflected by account- ought to work for the whole as well as theing allocations, except as they affect cash parts. A strategic commitment of capitaltaxes. For example, suppose a positive- to a line of business is an investmentNPV project sharply reduces book earn- project. If management does invest, theyings in its early stages. Finance theory must believe the value of the firm in-would recommend forging ahead, trust- creases by more than the amount of capi-ing investors to see through the account- tal committed — otherwise they areing bias to the projects true value. Empir- throwing money away. In other words,ical evidence indicates that investors do there is an implicit estimate of net presentsee through accounting biases; they do value.not just look naively at last quarters or This would seem to invite the applica-last years EPS. (If they did, all stocks tion of finance theory, which explainswould sell at the same price-earnings how real and financial assets are valued.ratio.) The theory should have direct application All these concepts are generally ac- not only to capital budgeting, but also tocepted by financial economists. The con- the financial side of strategic planning.cepts are broadly consistent with an up- Of course it has been applied to someto-date understanding of how capital extent. Moreover, strategic planningmarkets work. Moreover, they seem to be seems to be becoming more financiallyaccepted by firms, at least in part: any sophisticated. Financial concepts aretime a firm sets a hurdle rate based on stressed in several recent books on corpo-capital market evidence, and uses a DCF rate strategy [Fruhan 1979; Salter andformula, it must implicitly rely on the Weinhold 1979; and Beirman 1980]. Con-logic I have sketched. So the issue here is sulting firms have developed the con-not whether managers accept finance cepts strategic implications [Albertstheory for capital budgeting (and for other 1983].financial purposes). It is why they do not Nevertheless, I believe it is fair to sayuse the theory in strategic planning. that most strategic planners are notThe Gap Between Finance Theory and guided by the tools of modem finance.Strategic Planning Strategic and financial analyses are not I have resisted referring to strategic reconciled, even when the analyses are ofINTERFACES 14:1 128
  4. 4. FINANCE THEORYthe same major project. When low net ning seems extremely naive from a finan-present value projects are nurtured "for cial point of view. Sometimes capital mar-strategic reasons," the strategic analysis kets are ignored. Sometimes firms are es-overrides measures of financial value. sentially viewed as having a fixed stock ofConversely, projects with apparently high capital, so that "cash cows" are needed tonet present values are passed by if they finance investment in rapidly growingdont fit in with the firms strategic objec- lines of business. (The firms thattives. When financial and strategic pioneered in strategic planning actuallyanalyses give conflicting answers, the had easy access to capital markets, as doconflict is treated as a fact of life, not as an almost all public companies.) Firms mayanomaly demanding reconciliation. not like the price they pay for capital, but In many firms, strategic analysis is that price is the opportunity cost of capi- partly or largely directed to variables fi- tal, the proper standard for new invest- nance theory says are irrelevant. This is ment by the firm. another symptom of the gap, for example: The practical conflicts between finance (1) Many managers worry about a and strategy are part of what lies behind strategic decisions impact on book the recent criticism of US firms for al- rate of return or earnings per share. If legedly concentrating on quick payoffs at they are convinced the plan adds to the expense of value. US executives, the firms value, its impact on account- especially MBAs, are said to rely too ing figures should be irrelevant. much on purely financial analysis, and (2) Some managers pursue diversification too little on building technology, prod- to reduce risk — risk as they see it. ucts, markets, and production efficiency. Investors see a firms risk differently. The financial world is not the real world, In capital markets, diversification is the argument goes; managers succumb to cheap and easy. Investors who want the glamour of high finance. They give to diversify do so on their own. Cor- time and talent to mergers, spinoffs, un- porate diversification is redundant; usual securifies, and complex financing the market will not pay extra for it. packages when they should be out on the If the market were willing to pay extra factory fioor. They pump up current earn-for diversification, closed-end funds ings per share at the expense of long-runwould sell at premiums over net asset values.value, and conglomerate firms would be Much of this cridcism is not directedworth more to investors than their com- against finance theory, but at habits of fi-ponents separately traded. Closed-end nancial analysis that financial economistsfunds actually sell at discounts, not pre- are attempting to reform. Finance theorymiums. Conglomerates appear to sell at of course concentrates on the financialdiscounts too, although it is hard to prove world — that is, capital markets. How-it, since the firms components are not ever, it fundamentally disagrees with thetraded separately. implicit assumption of the critics, who say Much of the literature of strategic plan- that the financial world is not the realJanuary-February 1984 129
  5. 5. MYERSworld, and that financial analysis diverts standard discounted cash flow analyses ofattention from, and sometimes actively a series of major projects:undermines, real long-run values. The (1) Even careful analyses are subject toprofessors and textbooks actually say that random error. There is a 50 percentfinancial values rest on real values and probability of a positive NPV for athat most value is created on the left-hand truly border-line project.side of the balance sheet, not on the right. (2) Firms have to guard against these er- Finance theory, however, is under at- rors dominating project choice.tack too. Some feel that any quantitative (3) Smart managers apply the followingapproach is inevitably short-sighted. check. They know that all projectsHayes and Garvin, for example, have have zero NPV in long-run competi-blamed discounted cash flow for a sig- tive equilibrium. Therefore, a positivenificant part of this countrys industrial NPV must be explained by a short-rundifficulties. Much of their criticism seems deviation from equilibrium or by somedirected to misapplications of discounted permanent competitive advantage. Ifcash flow, some of which I discuss later. neither explanation applies, the posi-But they also believe the underlying tive NPV is suspect. Conversely, atheory is wanting; they say that "beyond negative NPV is suspect if a competi-all else, capital investment represents an tive advantage or short-run deviationact of faith" [Hayes and Garvin 1982, p. from equilibrium favors the project.79]. This statement offends most card- In other words, smart managers do notcarrying financial economists. accept positive (or negative) NPVs unless I do not know whether "gap" fully de- they can explain them.scribes all of the problems noted, or Strategic planning may serve to imple-hinted at, in the discussion so far. In ment this check. Strategic analyses looksome quarters, finance theory is effec- for market opportunities — deviationstively ignored in strategic planning. In from equilibrium — and try to identify theothers, it is seen as being in conflict, or firms competitive advantages.working at cross-purposes, with other Turn the logic of the example around.forms of strategic analysis. The problem is We can regard strategic analysis whichto explain why. does not explicitly compute NPVs asTwo Cultures and One Problem showing absolute faith in Adam Smiths Finance theory and strategic planning invisible hand. If a firm, looking at a linecould be viewed as two cultures looking of business, finds a favorable deviationat the same problem. Perhaps only differ- from long-run equilibrium, or if it iden-ences in language and approach make the tifies a competitive advantage, then (effi-two appear incompatible. If so, the gap cient) investment in that line must offerbetween them might be bridged by better profits exceeding the opportunity cost ofcommunication and a determined effort to capital. No need to calculate the invest-reconcile them. ments NPV: the manager knows in ad- Think of what can go wrong with vance that NPV is positive.INTERFACES 14:1 130
  6. 6. FINANCE THEORY The trouble is that strategic analyses are often misapplied. It may be an attempt to also subject to random error. Mistakes are get back to fundamentals. Remember, also made in identifying areas of competi- however: finance theory never left the tive advantage or out-of-equilibrium mar- fundamentals. Discounted cash flow kets. We would expect strategic analysts should not in principle bias the firm to calculate NPVs explicitly, at least as a against long-lived projects, or be swayed check; strategic analysis and financial by arbitrary allocations. analysis ought to be explicitly reconciled. However, the typical mistakes made in Few firms attempt this. This suggests the applying DCF do create a bias against gap between strategic planning and fi- long-lived projects. I will note a few nance theory is more than just "two cul- common mistakes.tures and one problem." Ranking on Internal Rate of Return The next step is to ask why reconcilia- Competing projects are often ranked ontion is so difficult. internal rate of return rather than NPV. ItMisuse of Finance Theory is easier to earn a high rate of return if The gap between strategic and financial project life is short and investment isanalysis may reflect misapplication of fi- small. Long-lived, capital-intensive proj-nance theory. Some firms do not try to ects tend to be put down the list even ifuse theory to analyze strategic invest- their net present value is substantial.ments. Some firms try but make mistakes. The internal rate of return does meas- I have already noted that in many firms ure bang per buck on a DCF basis. Firmscapital investment analysis is partly or may favor it because they think they havelargely directed to variables finance theory only a limited number of bucks. However,says are irrelevant. Managers worry about most firms big enough to do formalprojects book rates of return or impacts strategic planning have free access to capi-on book earnings per share. They worry tal markets. They may not like the price,about payback, even for projects that but they can get the money. The limits onclearly have positive NPVs. They try to capital expenditures are more often set in-reduce risk through diversification. side the firm, in order to control an or- Departing from theoretically-correct ganization too eager to spend money.valuation procedures often sacrifices the Even when a firm does have a strictly lim-long-run health of the firm for the short, ited pool of capital, it should not use theand makes capital investment choices ar- internal rate of return to rank projects. Itbitrary or unpredictable. Over time, these should use NPV per dollar invested, orsacrifices appear as disappointing growth, linear programming techniques when cap-eroding market share, loss of technologi- ital is rationed in more than one periodcal leadership, and so forth. [Brealey and Myers 1981, pp. 101-107]. The non-financial approach taken in Inconsistent Treatment of Inflationmany strategic analyses may be an at- A surprising number of firms treat infla-tempt to overcome the short horizons and tion inconsistently in DCF calculations.arbitrariness of financial analysis as it is High nominal discount rates are used butJanuary-February 1984 131
  7. 7. MYERScash flows are not fully adjusted for fu- are worked out for anticipated challenges.ture inflation. Thus accelerating inflation Most projects that get to the top seem tomakes projects — especially long-lived meet profitability standards set by man-ones — look less attractive even if their agement.real value is unaffected. According to Brealey and Myerss Sec-Unrealistically High Rates ond Law, "The proportion of proposed Some firms use unrealistically high dis- projects having positive NPV is indepen-count rates, even after proper adjustment dent of top managements estimate of thefor inflation. This may reflect ignorance of opportunity cost of capital" [Brealey andwhat normal returns in capital markets Myers 1981, p. 238].really are. In addition: Suppose the errors and biases of the(1) Premiums are tacked on for risks that capital budgeting process make it ex- can easily be diversified away in tremely difficult for top management to stockholders portfolios. verify the true cash flows, risks and pre-(2) Rates are raised to offset the optimistic sent value of capital investment propo- biases of managers sponsoring proj- sals. That would explain why firms do not ects. This adjustment works only if try to reconcile the results of capital the bias increases geometrically with budgeting and strategic analyses. How- the forecast period. If it does not, ever, it does not explain why strategic long-lived projects are penalized. planners do not calculate their own(3) Some projects are unusually risky at NPVs. inception, but only of normal-risk We must ask whether those in top once the start-up is successfully management — the managers who make passed. It is easy to classify this type strategic decisions — understand finance of project as "high-risk," and to add a theory well enough to use DCF analysis start-up risk premium to the discount effectively. Although they certainly rate for all future cash flows. The risk understand the arithmetic of the calcula- premium should be applied to the tion, they may not understand the logic of startup period only. If it is applied the method deeply enough to trust it or to after the startup period, safe, short- use it without mistakes. lived projects are artifically favored. They may also not be familiar enough Discounted cash flow analysis is also with how capital markets work to use cap-subject to a difficult organizational prob- ital market data effectively. The wide-lem. Capital budgeting is usually a spread use of unrealistically high discountbottom-up process. Proposals originate in rates is probably a symptom of this.the organizations midriff, and have to Finally, many managers distrust thesurvive the trip to the top, getting ap- stock market. Its volatility makes themproval at every stage. In the process polit- nervous, despite the fact that the volatilityical alliances form, and cash flow forecasts is the natural result of a rational market. Itare bent to meet known standards. An- may be easier to underestimate theswers — not necessarily the right ones — sophistication of the stock market than toINTERFACES 14:1 132
  8. 8. FINANCE THEORY accept its verdict on how well the firm is mission the Gallup Poll to extract proba- doing. bUity distributions from the minds of in- Finance Theoiy May Have Missed the Boat vestors. However, we have extensive evi- Now consider a firm that understands dence on past average rates of return in finance theory, applies DCF analysis cor- capital markets [Ibbotsen and Sinquefield rectly, and has overcome the human and 1982] and the corporate sector [Holland organizational problems that bias cash and Myers 1979]. No long-run trends in flows and discount rates. Carefully esti- "normal" rates of return are evident. Rea- mated net present values for strategic in- sonable, ballpark cost of capital estimates vestments should help significantly. can be obtained if obvious traps (for However, would they fully grasp and de- example, improper adjustments for risk or scribe the firms strategic choices? Perhaps inflation) are avoided. In my opiruon, es- not. timating cash flows properly is more im- There are gaps in finance theory as it is portant than fine-tuning the discount rate. usually applied. These gaps are not Forecasting Cash Flow necessarily intrinsic to finance theory If s impossible to forecast most projects generally. They may be filled by new ap- actual cash flows accurately. DCF calcula- proaches to valuation. However, if they tions do not call for accurate forecasts, are the firm will have to use something however, but for accurate assessments of more than a straightforward discounted the mean of possible outcomes. cash flow method. Operating managers can often make An intelligent application of discounted reasonable subjective forecasts of thecash flow will encounter four chief problems: operating variables they are responsible(1) Estimating the discount rate, for — operating costs, market growth,(2) Estimating the projects future cash flows, market share, and so forth — at least for(3) Estimating the projects impact on the the future that they are actually worrying firms other assets cash flows, that is about. It is difficult for them to translate through the cross-sectional links be- this knowledge into a cash flow forecast tween projects, and for, say, year seven. There are several(4) Estimating the projects impact on the reasons for this difficulty. First, the firms future investment oppor- operating manager is asked to look into a tunities. These are the time series far future he is not used to thinking ab- links between projects. out. Second, he is asked to express his The first three problems, difficult as forecast in accounting rather than operat-they are, are not as serious for financial ing variables. Third, incorporating fore-strategy as the fourth. However, I will re- casts of macroeconomic variables is dif-view all four. ficult. As a result, long-rim forecasts oftenEstimating the Opportunity Cost of Capital end up as mechanical extrapolations of The opportunity cost of capital will al- short-run trends. It is easy to overlook theways be difficult to measure, since it is an long-run pressures of competition, infla-expected rate of return. We cannot com- tion, and technical change.January-February 1984 133
  9. 9. MYERS It should be possible to provide a better second-stage must depend on the first: ifframework for forecasting operating var- the firm could take the second projectiables and translating them into cash without having taken the first, then theflows and present value — a framework future opportunity should have no impactthat makes it easier for the operating on the immediate decision. However, ifmanager to apply his practical knowledge, tomorrows opportunities depend on to-and that explicitly incorporates informa- days decisions, there is a time-series linktion about macroeconomic trends. There between projects.is, however, no way around it: forecasting At first glance, this may appear to beis intrinsically difficult, especially when just another forecasting problem. Whyyour boss is watching you do it. not estimate cash flows for both stages,Estimating Cross-Sectional Relationships and use discounted cash flow to calculateBetween Cash Flows the NPV for the two stages taken to- Tracing "cross-sectional" relationships gether?between project cash flows is also intrinsi- You would not get the right answer.cally difficult. The problem may be made The second stage is an option, and con-more difficult by inappropriate project de- ventional discounted cash flow does notfinitions or boundaries for Unes of busi- value options properly. The second stagenesses. Defining business units properly is an option because the firm is not com-is one of the tricks of successful strategic mitted to undertake it. It will go ahead ifplanning. the first stage works and the market is still However, these inescapable problems attractive. If the first stage fails, or if thein estimating profitability standards, fu- market sours, the firm can stop afterture cash returns, and cross-sectional in- Stage 1 and cut its losses. Investing interactions are faced by strategic planners Stage 1 purchases an intangible asset: aeven if they use no financial theory. They call option on Stage 2. If the options pre-do not reveal a flaw in existing theory. sent value offsets the first stages negativeAny theory or approach encounters them. NPV, the first stage is justified.Therefore, they do not explain the gap be- The Limits of Discounted Cash Flowtween finance theory and strategic plan- The limits of DCF need further explana-ning. tion. Think flrst of its application to fourThe Links Between Todays Investments types of securities: and Tomorrows Opportunities (1) DCF is standard for valuing bonds, The fourth problem — the link between preferred stocks and other fixed- todays investments and tomorrows op- income secvirities. portunities — is much more difficult. (2) DCF is sensible, and widely used, for Suppose a firm invests in a negative- valuing relatively safe stocks payingNPV project in order to establish a foot- regular dividends. hold in an attractive market. Thus a valu- (3) DCF is not as helpful in valuing com- able second-stage investment is used to panies with signiflcant growth oppor- justify the immediate project. The tunities. The DCF model can beINTERFACES 14:1 134
  10. 10. FINANCE THEORY stretched to say that Apple Com- (4) DCF is no help at all for pure research puters stock price equals the present and development. The value of R&D value of the dividends the firm may is almost all option value. Intangible eventually pay. It is more helpful to assets value is usually option value. think of Apples price, Po, as: The theory of option valuation has been worked out in detail for securities — not Pn = = PVGO, only puts and calls, but warrants, conver- tibles, bond call options, and so forth. The where solution techniques should be applicable EPS = normalized current earnings to the real options held by firms. Several r = the opportimity cost of capital preliminary applications have already PVGO = the net present value of future been worked out, for example: growth opportunities. (1) Calculations of the value of a Federal Note that PVGO is the present value lease for offshore exploration for oil or of a portfolio of options — the firms gas. Here the option value comes from options to invest in second-stage, the lessees right to delay the deci- third-stage, or even later projects. sions to drill and develop, and to (4) DCF is never used for traded calls or make these decisions after observing puts. Finance theory supplies option the extent of reserves and the future valuation formulas that work, but the level of oil prices [Paddock, Siegel, option formulas look nothing like and Smith 1982]. DCF. (2) Calculating an assets abandonment or Think of the corporate analogs to these salvage value: an active second-handsecurities: market increases an assets value,(1) There are few problems in using DCF other things equal. The second-hand to value safe flows, for example, flows market gives the asset owner a put op- from financial leases. tion which increases the value of the(2) DCF is readily applied to "cash cows" option to bail out of a poorly perform- — relatively safe businesses held for ing project [Myers and Majd 1983]. the cash they generate, rather than for The option "contract" in each of these strategic value. It also works for "en- cases is fairly clear: a series of calls in the gineering investments," such as first case and a put in the second. How- machine replacements, where the ever, these real options last longer and are main benefit is reduced cost in a more complex than traded calls and puts. clearly-defined activity. The terms of real options have to be ex-(3) DCF is less helpful in valuing busi- tracted from the economics of the problem nesses with substantial growth oppor- at hand. Realistic descriptions usually tunities or intangible assets. In other lead to a complex implied "contract," re- words, it is not the whole answer quiring numerical methods for valuation. when options account for a large frac- Nevertheless, option pricing methods tion of a business value. hold great promise for strategic analysis.January-February 1984 135
  11. 11. MYERSThe time-series links between projects are gibles is not ignored by good managersthe most important part of financial even when conventional financial tech-strategy. A mixture of DCF and option niques miss them. These values may bevaluation models can, in principle, de- brought in as "strategic factors," dressedscribe these links and give a better under- in non-financial clothes. Dealing with thestanding of how they work. It may also be fime series links between capital invest-possible to esfimate the value of particular ments, and with the opfion value thesestrategic options, thus eliminating one links create, is often left to strategic plan-reason for the gap between finance theory ners. But new developments in financeand strategic planning. theory promise to help.Lessons for Corporate Strategy Bridging the Gap The task of strategic analysis is more We can summarize by asking how thethan laying out a plan or plans. When present gap between finance theory andtime-series links between projects are im- strategic planning might be bridged.portant, its better to think of strategy as Strategic planning needs finance. Pre-managing the firms portfolio of real op- sent value calculafions are needed as ations [Kestler 1982]. The process of finan- check on strategic analysis and vice versa.cial planning mdy be thought of as: However, the standard discounted cash(1) Acquiring options, either by investing fiow techniques will tend to understate directly in R&D, product design, cost the option value attached to growing, pro- or quality improvements, and so fitable lines of business. Corporate finance forth, or as a by-product of direct capi- theory requires extension to deal with real tal investment (for example, inveshng options. Therefore, to bridge the gap we in a Stage 1 project with negative NPV on the financial side need to: in order to open the door for Stage 2). (1) Apply exisfing finance theory cor-(2) Abandoning options that are too far rectly. "out of the money" to pay to keep. (2) Extend the theory. I believe the most(3) Exercising valuable options at the promising line of research is to try to right time — that is, buying the cash use option pricing theory to model the producing as^sets that ultimately pro- fime-series interactions between in- duce positive net present value. vestments. There is also a lesson for current appli- Both sides could make a conscious ef- cations of finance theory to strategic is- fort to reconcile financial and strategic sues. Several new approaches to financial analysis. Although complete reconcilia- strategy use a simple, traditional DCF tion will rarely be possible, the attempt model of the firm, [For example, Fruhan should uncover hidden assumptions and 1979, Ch. 2]. These approaches are likely bring a generally deeper understanding of to be more useful for cash cows than for strategic choices. The gap may remain, growth businesses with substantial risk but with better analysis on either side and intangible assets. of it. The option value of growth and intan-INTERFACES 14:1 136
  12. 12. FINANCE THEORYReferences Alberts, W. A. and McTaggart, James M. 1984, "Value based strategic investment planning," Interfaces, Vol. 14, No. 1 0anuary-February), pp. 138-151. Bierman, H. 1980, Strategic Financial Planning, The Free Press, New York. Brealey, R. A. and Myers, S. C. 1981, Princi- ples of Corporate Finance, McGraw-Hill Book Company, New York.Foster, G. 1978, Financial Statement Analysis, Prentice-Hall, Inc., Englewood Cliffs, New Jersey.Fruhan, W. E., Jr., 1979, Financial Strategy: Studies in the Creation, Transfer and Destruction of Shareholder Value, Richard D. Irwin, Inc., Homewood, Illinois.Hayes, R. H. and Garvin, D. A. 1982, "Manag- ing as if tomorrow mattered," Harvard Busi- ness Review, Vol. 60, No. 3 (May-June), pp. 70-79.Holland, D. M. and Myers, S. C. 1979, "Trends in corporate profitability and capital costs," in R. Lindsay, ed.. The Nations Capi- tal Needs: Three Studies, Committee on Eco- nomic Development, Washington, DC.Ibbotson, R. G. and Sinquefield, R. A. 1982, Stocks, Bonds, Bills and Inflation: The Past and the Future, Financial Analysts Research Foundation, Charlottesville, Virginia.Myers, S. C. and Majd, S. 1983, "Applying op- tion pricing theory to the abandonment value problem," Sloan School of Management, MIT, Working Paper.Paddock, J. L.; Siegel, D.; and Smith, J. L. 1983, "Option valuation of claims on physical assets: the case of offshore petroleum leases," Working Paper, MIT Energy Labora- tory, Cambridge, Massachusetts.Salter, M. S. and Weinhold, W. A. 1979, Di- versification Through Acquisition, The Free Press, New York.January-February 1984 137

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