CHAPTER 2

STRATEGY AND CAPITAL

ALLOCATION

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

Concept of Strategy

Chandler defined strategy as the determination of the basic longterm 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 firms strengths and weaknesses

with the opportunities and threats present in the external
environment.

Formulation of Strategies
Internal Analysis

Environmental Analysis
Customers
Competitors
Suppliers
Regulation
Infrastructure
Social/political
environment

Technical know-how
Manufacturing capacity
Marketing and
distribution capability
Logistics
Financial resources

Strengths and weaknesses

Opportunities and threats

Determine core capabilities

Identify opportunities
Find the fit between
core capabilities and
external opportunities
Firms strategies

The Thrust of Grand Strategy

Grand
Strategy

Growth

Concentration

Stability

Vertical
integration

Diversification

Contraction

Liquidation

Divestiture

Strategies, Principal Motivations, and Likely Outcomes

Principal
Strategy
Concentration

Motivations
- Ability to serve a

Likely Outcomes
Profitability
High

Growth
Moderate

Risk
Moderate

growing market
- Familiarity with technology
and market
- Cost leadership
Vertical integration

- Greater stability for existing

and proposed operations

High

Moderate

Moderate

High

Moderate

Moderate

- Greater market power

Concentric
diversification
Conglomerate
diversification

- Improves utilisation of
resources
- Limited scope in the present

Moderate

High

Low

business

Stability

- Satisfaction with status quo

High

Low

Low

Divestment

- Inadequate profit

High

Low

Low

- Poor strategy

Diversification Debate
Pros and Cons
Reduces overall risk exposure
Expands opportunities for growth
Dampens profitability

Diversification and Risk Reduction

ROI

(A+B)

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

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

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

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.

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?

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 subcontracting 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 companys 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.

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 Electrics
stoplight matrix, and the Mckinsey matrix.

BCG Matrix
Market Share
M
a
r
k
e
t
G
r
o
w
t
h
R
a
t
e

High
High

Low

Low

Stars

Question
Marks

Cash
Cows

Dogs

Pattern of Capital Allocation

Part A
Stars
Cash cows
(funds generated)

Question marks
Dogs on divestment
(funds released)

Part B
Stars

Question marks

1
Cash cows

Dogs

General Electrics Stoplight Matrix

Business Strength

I
n
d
u
s
t
r
y

A
t
t
r
a
c
t
i
v
e
n
e
s
s

Strong

Average

Weak

H
i
g
h

Invest

Invest

Hold

M
e
d
i
u
m

Invest

Hold

Divest

L
o
w

Hold

Divest

Divest

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
Criteria

Competitive Position
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

Assessment of the SBU Factory Automation

Industry Attractiveness
Criteria
Industry size
Industry growth
Industry profitability
Capital intensity
Technological stability
Competitive intensity
Cyclicality

Weight

Rating

Weighted Score

0.10
0.30
0.20
0.05
0.10
0.20
0.05

4
4
3
2
2
3
2

0.40
1.20
0.60
0.10
0.10
0.60
0.10
3.10

Competitive Position
Key Success Factors
Market share
Technological know how
Product quality
After-sales service
Price competitiveness
Low operating costs
Productivity

Weight
0.15
0.25

Rating
4
5

0.15
0.20
0.05
0.10
0.10

4
3
4
4
5

Weight Score
0.60
1.25
0.60
0.60
0.20
0.40
0.50
4.15

The McKinsey Matrix

Competitive Position

I
n
d
u
s
t
r
y

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

Market-Activated Corporate Strategy (MACS) Framework

Source: McKinsey & Company

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

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

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

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 maximization, many

corporate boards and senior managements commit to other objectives.

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.

Business Level Strategies

Diversified firms dont 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 Porters 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

Strategy of Cost Leadership:

Dell Computer Corporation
Direct selling

Built-to-order manufacturing

Low cost service

Negative working capital

Porters Generic Competitive Strategies

Sources of Competitive Advantage:
Unique Value as
Perceived by
Customer
Broad
(industry-wide)
Strategic Scope
Narrow
(segment only)

Lowest Cost

Overall
Differentiation

Overall Cost
Leadership

Focused
Differentiation

Focused Cost
Leadership

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.

Strategic Planning and Capital Budgeting

Environmental
assessment

Managerial vision,
values, and attitudes

Corporate
appraisal

Strategic plan

Capital
budgeting

Product strategy,
market strategy,
production strategy,
and so on

Generic Strategies and Key Options

Status Quo

FS

Concentric Diversification

Conglomerate
Diversification

Concentration
FOCUS

Diversification

Conservative

COST
LEADERSHIP
Aggressive

CA
Divestment

Liquidation

Vertical
Integration
IS

Defensive

Competitive

GAMESMANSHIP

Concentric
Merger

DIFFERENTIATION Conglomerate Merger

Turnaround

Retrenchment
ES

SUMMARY

Capital budgeting is not the exclusive domain of financial analysts and

accountants. Rather, it is a multifunctional task linked to a firms 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 worthwhileness.

Strategy involves matching a firms 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.

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 Electrics stoplight matrix , and the Mckinsey matrix.

Diversified firms dont 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 Porters
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.