1. Economic Foundations of Strategy
Power Point Set #3

2. 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.

3. 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

5. 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

7. 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)

13. 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?

14. 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

15. 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.

16. 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)

17. 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).

18. 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).

19. 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

20. 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

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

22. Economic Value Added (EVA)
Former CEO Roberto Goizueto introduced EVA to Coca-Cola in 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)

23. 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

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