449
Business BADM Strategy / Management
Policy
Class #2
Purpose of Strategy
Any viable business generates:
Value Added = Sales revenue Cost of Material
Inputs
VA distributed among employees, lenders,
shareholders, government, etc.
Based on what mechanisms/principles is this
distribution done? In other words, what determines
who will get how much and why?
Purpose of Strategy
Interestingly, different laws and different countries
give different mandates to managers:
Continuity of the enterprise (Netherlands)
National interest (France)
Shareholder AND employee interest (Germany)
Shareholder interest (English-speaking countries)
We will assume management of the enterprise in the
interest of the shareholders.
So what do the shareholders want the CEO to do?
How easy is it for the shareholders to motivate the CEO
to do it?
Goals, Values, and Performance
What might managers do if they are told that they
will be evaluated based on short term accounting
profits?
Maximizing profits entails potential problems:
Total profit, profit rate, or some other returns?
Short, medium, or long-term profits?
Accounting, economic, or some other type?
Goals, Values, and Performance (2)
Economic value added is a widely used performance
measure. It is the net operating profit after tax less
cost of capital, calculated as the total capital
employed times weighted average cost of capital:
EVA = NOPAT -WACC
EVA introduces more discipline in deploying and
allocating capital. However
The problem of short, medium, and long run, still
not resolved. Why? Need another measure of
performance to capture the temporal dimension
Goals, Values, and Performance (3)
Value of the enterprise, NPV of future free
cash flows:
Ct
(1 + r
t
e+ d
)
t
Ct - free cash flow in year t (net operating profit
plus depreciation less taxes less investment in
fixed and working capital)
re+d - weighted average cost of capital (cost of
equity times the relative share of equity PLUS the
cost of debt times the relative share of debt)
Example 1: Anheuser-Busch
Operating profit $1,756 million, taxes $617 million. Hence
NOPAT = $1,756 - $617 = $1,139 million
Financing:
67% equity at 14.3% (risk-free rate of interest PLUS riskpremium, which is the excess of the stock market rate of
return over the risk-free rate multiplied by A-Bs beta
coefficient)
33% debt at 5.2% (this is easy, the cost of borrowing)
re+d = .33*5.2 + .67*14.3 = 11.3%
Total capital $8 billion, so WACC = 11.3% * $8 B =
$904 million
Finally: EVA = $1,139 - $904 = $235 million
Example 2: Anheuser-Busch
A-B is considering licensing a proprietary technology to an
overseas brewing company for a period of 5 years. The
agreement would generate $50 million in free cash flows
annually. Assuming a discount rate of 12.5% and lump sum
flows of $50 million at the end of year 1, year 2, up to year
5, what is the NPV that AB is looking at?
What would be the NPV if the inflows started at the end of
year 2, due to the fact that the partner would have to build a
new facility?
Use of NPV
We can evaluate different strategies and/or major
irreversible decisions following an intuitive
methodology:
Identify alternatives
Estimate future cash flows associated with each one
Estimate implications for the cost of capital (do you
need to borrow a great deal?)
Pick the alternative with the highest NPV
NPV of future cash flows
Nice as a concept, but difficult to estimate!
Market fluctuations
Competitor actions
Technological uncertainty
Changes in regulation and trade patterns
Difficult to see how different strategic actions affect
them, especially when they may interact, say across
organizational units or when there is significant a real
option aspect to investments.
We will need to use judgment and other measures
such as COGS/Sales, Inventory Turnover, SGA
Expenses/Sales, etc. to evaluate performance and
link it to action.
Measuring Value/Performance (4):
Real Options
Buying a right but not an obligation to do something
in the future.
Rationale: Resolution of uncertainty in the mean
time.
If the outcome is bad abandon the project
If the outcome is good continue, but now with much
more certain payoffs to any additional investment.
The whole proposition now becomes more attractive
Many investments in new technologies have optionlike properties. They can open new markets,
underlie derivative technologies, etc.
Capital Market Approaches to Measuring
Performance (5)
We (or the shareholders) can also harness the brain
power of Wall Street and the entire stocktrading public to assess how well a firm is doing:
Market Value Added (MVA): Market Value less Total
Investment
Tobins q (Market Value/Book Value): a firms market
value divided by its replacement cost
The Market Value of the Firm: Current Value of all
securities issued by the firm
Problems with Maximizing Shareholder
Wealth
Cognitive: What does maximizing shareholder value
mean to a store or even division manager at WalMart?
Motivational: How about other stakeholder, and
doing the right thing for the community?
Paradox: those who focus too much on profits and
profitability dont end up performing that well!
Back full circle: Mission statements, effective
leadership, and formulation of understandable
strategies.
Balanced Scorecard (6)
How do we look to shareholders?
Cash flows, sales and income growth, etc.
How do customers see us?
On-time delivery, quality, innovation, etc.
What must we excel at?
Productivity, employee skills, cycle times, cost/quality
controls, etc.
Can we continue to improve and create value?
PuttingPerformanceinPerspective
Narrow
Stakeholder Perspective
Share Price
Accounting Profit
Past
Future
Economic Profit
DCF
Survival
Balanced Scorecard
Stakeholders View
Broad
Stakeholder Perspective
15
Example 2A: Anheuser-Busch
What would be the NPV of an analogous agreement with
infinite time horizon (instead of 5 years), starting to
generate flows at the end of year 1?
What would be the NPV if the flows started at the end of
year 2?
*** What would be the NPV of the flows starting at the end
of year 2 ($50 million) and then increasing by 2% each
year? ($51 million at the end of year 3, etc.)? ***
Example 2A: Anheuser-Busch
Example 3: Analyzing Investments
Consider a new technology that would costs an immediate
$100 million and another $100 million at the end of year 1.
It is estimated that the technology will be successful with
probability 50%. If successful, the technology will generate
free cash flows of $80 million starting at the end of year 2
up to infinity. If unsuccessful, the technology will generate
no cash flows. Assuming a discount rate of 20%, what is the
NPV of investing in this technology?
Example 3: Analyzing Investments
Example 3A: Enter Real Options
We could pay extra money upfront and rearrange the project
so that the uncertainty about the success of the technology is
resolved before we have to make the second investment. To
do so would require an immediate $110 million investment.
If the technology is unsuccessful we will abandon the
project. If the technology is successful, we will have to
invest another $100 million at the end of year 1, and the
technology will generate free cash flows of $80 million
starting at the end of year 2 up to infinity, as in the previous
case. Assuming a discount rate of 20%, what should we do
now?