Economics of Organization Power Point Set #3

The First Rule of Strategy: A Good Strategy Is “Coherent.” Functional pieces of strategy support the whole (Michael Porter) Oper. Strategy Finance Acctg. H.R. Mktg.

Strategic Coherence The Logic of How the Business Fits Together: Southwest Airlines Low Price Short Routes No Frills Point-to-Point One Aircraft - Boeing 737 High # of Aircraft per Route No Meals Flexible/ Lower Staffing American Airlines Premium Priced Short, Long, & Int’l Variety Hub & Spoke Multiple Aircraft Low # of Aircraft per Route Meals & Service Higher Staffing

A Basic Analytical Framework SWOT Analysis Strengths, Weaknesses, Opportunities, & Threats Strengths & Weaknesses Opportunities & Threats Values Of Management Values Of Stakeholders Strategy Internal Factors External Factors Drivers Objectives

Sustainable Competitive Advantage and the Measurement of Performance While we have said that the objective of strategy is to “create competitive advantage,” specifically we have the goal to maximize economic return. Static Measures of Performance Economic Profits ROA, ROE, ROC Dynamic Measures of Performance NPV Methods Capital Market Measures of Performance Market Value of the Firm MVA and EVA Tobin’s Q (James Tobin, Yale)

Problems With Shareholder Wealth Maximization Under what conditions does “maximizing shareholder wealth” not make sense? When do we need to pay attention to other “stakeholders?” What are the social responsibilities of business to: Employees? Communities? Customers? The Issue: What are the “externalities,” and who bears the costs?

Dynamic Measures of Performance: NPV or DCF Analysis Competitive Advantage doesn’t happen over night; it evolves over time - So Profits may not be the best way to measure performance Finance vs. Strategy

Dynamic Measures of Performance NPV or DCF Analysis: The principle of discounted cash flow (DCF) analysis that firms apply to their individual projects can also be applied to the firm as a whole. Maximizing the net present value of the firm’s cash flow (“sustainable competitive advantage”) corresponds to maximization of its stock market valuation and hence maximizes the wealth of its shareholders.

Net Cash Flow EBT - t (EBT) EBT (1-t) = NET INCOME EBT (1-t) + depreciation - capital expenditures = NET CASH FLOW (note we are assuming no change in accounts receivable, no change in net working capital, no change in inventory) Equivalent concepts: Maximize NPV DCF Approach Maximize Economic Profits (EVA) Sustainable Competitive Advantage (SCA)

Limitations of Present Value Measures Projections are only as good as the ability of managers to measure accurately the financial consequences of actions. An implicit assumption of value-based strategy was that business units and all investment proposals were self-contained. It was usually expected that divesting a business or curtailing an investment project would have no financial repercussions elsewhere in the corporation (e.g., ignores knowledge transfers).

Limitations of Present Value Measures Strict financial measurement of many long-term investments, particularly in intangible assets, is virtually impossible. Investments in R&D typically do not offer direct returns; their value is an option to invest in new products and processes that may arise from R&D. Narrowly- defined DCF does not accurately value investments where there is significant options value. (Note: Merck has been at the forefront of applying options theory to analyze investments in R&D).

Capital Market Approaches To Measuring Performance Market Value Added (MVA) Market Value less Total Investment Economic Value Added (EVA) Operating Profit (after tax) less annual capital costs; basically, this is economic profit Tobin’s q (Market Value/Book Value) a firm’s market value divided by its “replacement” cost The Market Value of the Firm - Current Value of all securities issued by the firm

Economic Value Added (EVA) Anheuser-Busch Operating profit $1,756 million - taxes $617 million = $1,139 million WACC : 67% equity at 14.3% 33% debt at 5.2% 11.3% WACC

Economic Value Added (EVA) WACC = 11.3% Capital of $8 billion 11.3% * $8billion = $904 million $1,139 - $904 = $235 million is the EVA

Economic Value Added (EVA) Former CEO Roberto Goizueto introduced EVA to Coca-Cola in 1987. Its impact has been to encourage: Divestment (e.g., pasta, wine, instant tea) where returns failed to cover the cost of capital Increased leverage (i.e., cost of equity far exceeded the cost of debt. Their WACC fell from 16% to 12%) Increased efficiency (e.g., inefficient plants shut down)

The Context Of Strategy Formulation Continuous Monitoring Of Strategic Situation Decisive Moments In The Company’s History Boeing and the 747 Nucor and the Continuous Strip Mill

Key Characteristics Of Strategic Decisions Important Not Easily Reversible Significant Commitment Of Resources Involves Alternatives, Consequences, and Choice Some Level of Uncertainty Typically Involved