Module 6 COMPETITIVE ADVANTAGE - Windows advantage Governance Institute of Australia / 2017 6 – 1...

Module 6

COMPETITIVE ADVANTAGE

CONTENTS Preview 6 – 1 Introduction 6 – 1

Module objectives 6 – 1

Why this module is important 6 – 1

Structure of this module 6 – 2

Investing and strategic planning 6 – 2 Elements of the strategic planning process 6 – 2

Corporate mission 6 – 3

Corporate objectives 6 – 3

Corporate strategies 6 – 3

Operating long-term plans 6 – 4

Short-term budgets 6 – 4

Business plans 6 – 5

Competitive advantage and other strategic tools 6 – 5 Competitive advantage — The source of SUCCESS 6 – 6

SWOT analysis 6 – 7

Strategic matrices 6 – 8

Guiding principles for cash flow estimation 6 – 9 Cash flow from assets (free cash flows) 6 – 10

Incremental (or with/without) principle 6 – 10

Stand-alone principle 6 – 11

The consistency principle 6 – 11

Common capital budgeting errors 6 – 12 Error 1 — The wrong planning horizon 6 – 12

Error 2 — Double counting interest expense 6 – 12

Error 3 — Inconsistent treatment of inflation 6 – 12

Quantitative risk management tools 6 – 13 Sensitivity analysis 6 – 13

Scenario analysis 6 – 13

Simulation 6 – 13

Qualitative risk management tools 6 – 14

Module review 6 – 14

Checklist 6 – 15

Readings 6 – 17 Key readings 6 – 17

Optional readings/background references 6 – 17

Quiz 6 – 19

Competitive advantage

Governance Institute of Australia / 2017 6 – 1

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PREVIEW Introduction Capital budgeting is perhaps the most critical decision area for management. Decisions about long-term assets are usually very hard to reverse and have a greater impact on share price if right or wrong than decisions about inventory or financing mix. Financial evaluation of alternative capital projects involve applying one or more of the six project selection techniques, although we have seen that net present value is by far the most superior technique.

The financial evaluation of long-term assets is not the only step in capital budgeting. We saw in our discussion in Module 5, that it is but one step out of five. It is important, for example, which management team implements the decision. Their credibility is a critical component in obtaining credit so it should be thoughtfully handled before an approach to a bank is made. In fact, the whole strategic planning cycle is important.

Success without strategic planning requires a lot more luck.

Another way investment decisions can be poorly handled is when the right project selection techniques are used but they are misapplied. This is not an uncommon mistake at all. It may seem obvious to us looking at an investment decision from the big picture perspective, but those embroiled in it sometimes cannot see the woods for the trees. For example, if firms forecast future costs and benefits allowing for inflation, then they should also allow for inflation in the discount rate applied to future cash flows.

Another example is when an organisation decides to enter a growth area (eg wine, leisure, telecommunications and computing) but they have little prior relevant experience or skill to that area. An Australian example was the wine acquisition by Southcorp of the Oatley family Rosemount Estate. Southcorp paid $1.5 billion to merge with Rosemount Estate in 2001, but integration was poorly handled in a chain of events that would lead to the Foster’s takeover of Southcorp in 2005.

This module addresses three major issues:

• the importance of strategic planning and its relationship to investing

• the principles involved in estimating the cash flows of a project to be used in the capital budgeting techniques covered in Module5 including common errors in project evaluation

• some techniques for considering the project’s risk.

Module objectives • To explain the strategic planning steps and their role in investment decisions

• To articulate the three main strategic tools (ie SUCCESS analysis, SWOT analysis and strategic matrices)

• To explain the three key principles for correctly estimating relevant cash flows (ie with/without, stand-alone and consistency principles)

• To use these principles to estimate relevant free cash flows for capital budgeting

• To apply the various capital budgeting risk management tools

Why this module is important A common error made by management and analysts is to forecast wildly positive benefits from investing. This module is important because it addresses the two main causes of this capital budgeting error. First, it highlights the importance of competitive advantage in justifying cash flows. Unless management can identify at least one competitive advantage, their forecast benefits will be just that — forecasts. They will not reflect the reality.

Corporate Financial Management

6 – 2 Governance Institute of Australia / 2017

The second problem involves errors in assessing which cash flows to include in the cost-benefit calculation and how to include them. A common example of such an error is the double counting of interest expense. Many cost benefit analyses include it in one place but are unaware that they have implicitly included it already elsewhere. This module seeks to address these major errors and thus help management make better investment decisions to maximise shareholders’ wealth or market value.

Structure of this module • Investing and strategic planning

• Competitive advantage and other strategic tools

• Guiding principles for cash flow estimation

• Common capital budgeting errors

• Quantitative risk management tools

• Qualitative risk management tools

INVESTING AND STRATEGIC PLANNING Having established that investment decisions can have a more profound effect on the firm’s wealth than financing decisions, in Module 5 we reviewed six alternative project selection techniques that are commonly used. Decisions about long-term assets are harder to reverse and have a greater impact on share price if right or wrong. How the financial numbers perform via a quantitative evaluation of the costs and benefits of a potential business venture is certainly important. However, it is not just a matter of calculating a net present value or return on investment and then writing up a glossy business plan for the bank. Financiers will want to see how the financial forecasts are integrated with marketing and production strategies into a business plan.

Before a firm embarks upon a new product line or business venture investment, management can increase the likelihood of its success by strategic planning. The strategic planning process ensures we identify why we think success is likely to occur, helps us to plan for it to occur and then checks how successfully it has been implemented.

Elements of the strategic planning process Strategic planning assists managers in developing investment strategies. It does this by identifying and evaluating growth opportunities for both existing lines of business and potential new ones. Strategic planning allows managers to search in a systematic and structured way for investment opportunities that are compatible with the firm’s existing strengths and capabilities.

Strategic planning is the means by which managers, work out the various corporate strategies to implement so as to achieve their overall mission and specific corporate objectives. The following diagram, Figure 1, describes this process.



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Figure 1 — Strategic planning

Corporate mission The organisation’s overall mission is usually stated in broad, somewhat vague philosophical terms. Such a mission statement is suitable for public consumption because it does not give away too many secrets but still gives a general picture of the firm’s activities.

Question A What is the mission statement for your (or another) organisation? Extract the exact words. How long ago was it developed? Who developed it? How is it used in your organisation?

Corporate objectives The corporate objectives are specific operational goals for management to attain. Top management in conjunction with the board of directors sets these. These include goals such as a 15 per cent return on shareholders’ funds, 45 per cent share of the market, leader in the development of new products, and a share price in excess of $4.00. While all these are interesting objectives, it is worth noting that all of these specific objectives are reflected in the last one — share price.

The primary function of management should be to increase the current value of the firm. For listed firms, this is reflected in their share price. It’s no use telling shareholders that have experienced an 80 per cent decline in the share price, and therefore their wealth, that they should be content because the firm has achieved their objective of 45 per cent share of the market!

Corporate strategies Corporate strategies are the broad approaches that are to be taken to achieve the specific corporate objectives. Corporate strategies also communicate top management’s expectations and priorities, what they see as the potential areas of business development to investigate or problem areas to rectify. Priorities are set and broad responsibility given for ensuring they are pursued and achieved.

Ideally, each strategic business unit should have their own strategies formulated to help them achieve their objectives. A strategic business unit (SBU) may be defined as any subsidiary business in the firm that could be separated out to operate independently or even sold. An SBU is typically a customer or product group although it may be a particular geographical area.



While the strategies for each SBU can end up on five or six pieces of paper, if done properly, they should reflect many hours of discussion, research and brainstorming. They reflect how the firm or SBUs expect to achieve their objective. Basically, they achieve this by exploiting their special competitive advantages that in an otherwise very competitive market should cause profits to be generated in sufficient quantities to satisfy shareholders. Once a firm loses its distinctive competitive advantage due to imitation or superior performance by competitors, there is clearly no further value to be gained. This also ensures that firms attempt to exploit as much value in the early phase of a product’s life cycle. Corporate strategies need to address areas of weakness (eg product quality).

Three techniques used to aid this step in the process, SUCCESS and SWOT analysis and strategic matrices, are further explored below.

Operating long-term plans Operational plans are developed by lower level management to achieve corporate strategies. Once developed, they are typically forwarded for approval by senior management and directors. Operational plans involve the forecasting of the big picture numbers relating to the achievement of each strategy. The first phase of this is called capital budgeting. Once capital expenditure, expected revenues and expenses have been broadly estimated, the second phase can be pursued, whereby the requirements for external financing are identified. Each capital expenditure program is aimed at achieving one or more strategy. As such, management should prioritise specific projects to begin operation in the right sequence.

Clearly no plan should be pursued if the benefits do not outweigh the costs, that is, if value to shareholders is not added. This involves capital budgeting and forecasting the future. Some organisations select a three or five year time frame for their operational plans. It is more sensible however, to have a planning horizon that is at least as long as the duration of the firm’s expected competitive advantage.

Short-term budgets Short-term budgets are used for making day-to-day decisions. Management needs to check that the short-term budgets are consistent with the long-term operational plans established in the previous stage of the strategic planning process. There are two types of short-term budgets. The traditional rolling twelve-month budget refers to a detailed forecast of expected revenues and expenses by product line to ascertain expected profit. In essence, it is an estimate of the firm’s performance or ‘score’ at the end of the period. Bonuses are often linked for senior management of those SBUs that exceed budgeted profit.

The second type of short-term budget is a cash budget or cash forecast. Sometimes they are simply referred to as the firm’s ‘cash flow’. In essence, the purpose of this budget is to ascertain the ability of the firm to pay its bills. Some firms do a monthly cash forecast, others break up the cash inflows and outflows by weeks and others do it on a daily basis. While the latter is time consuming, such firms are prepared to devote this time because either the timing or the amounts involved are critical. As firms expand their sales, they need more funds for more inventory and to finance their new customers who purchase on credit. Many firms with a clear competitive advantage have fallen flat and subsequently failed because they grew too quickly following a successful marketing strategy. The cash flow forecast can help identify potential weaknesses.



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Question B Does your organisation have a rolling 12-month or a static profit forecast? Does your organisation forecast cash flow as well? If so, how regularly is it reforecast?

Smaller, less complex organisations may decide not to undertake all the steps in the strategic planning process identified above. In fact, if their competitive advantage is well defined and relates only to one product line, it may indeed be a simpler strategic planning process. In such cases, a business plan may serve for planning as well as its more typical role of selling the organisation to financiers.

Business plans Business plans typically contain strategic information, marketing plans, forecasted financial results and the profiles of key management and any other information the firm may deem useful to sell the firm’s prospects to current and potential financiers. They would contain a miniaturised reflection of the strategic planning process.

Question C Some organisations pursue somewhat ‘borderline’ ethical strategies to achieve profits (eg creative accounting, environmental exploitation, or activities that harm the local community in some way). Do you believe that such unethical behaviour is reflected in the current value of shares? Substantiate your opinion with examples.

COMPETITIVE ADVANTAGE AND OTHER STRATEGIC TOOLS Before an organisation proceeds with an investment it should be able to justify the quantitative cost benefit analysis with a qualitative review of competitive advantage. These are:

• SUCCESS analysis which attempts to explain a financial evaluation by one of the firm’s competitive advantages

• SWOT analysis which identifies the firm’s existing weaknesses and threats to future profitability and contrasts these with their existing strengths and likely opportunities

• Strategic matrix analysis (for example, BCG matrix, Porter value chain) which attempts to justify success in terms of several critical variables (eg market share and growth, cost minimisation and differentiation).



Competitive advantage — The source of SUCCESS Behind the numbers in a forecast or business plan must be some real source of wealth, namely competitive advantage. There are a number of ways of describing the true sources of economic profit including net present value, rate of return, unique or distinctive competence, barrier to competition, economic rents and sustainable comparable advantage. Without at least one of the following, then no matter how rosy the forecast, the decision should be to proceed no further.

Scale If production can be increased with a less than proportional increase in costs, then the average cost of producing declines. The Model T Ford was the trailblazer of assembly line economies of scale. Economies of scale however can be achieved in marketing, distribution or administration. Potential competitors are disadvantaged because of the requirements for substantial capital and the potential to weather a price war. Economies of specialisation or experience can also serve to advantage the firm.

Uniqueness Independent of economies of scale, firms can have various unique advantages such as unique location (eg service stations, supermarkets, restaurants) or access to low-cost raw materials (eg a government electricity supply contract). Proprietary technology such as a patent is also another unique cost advantage over potential competitors.

Culture Some companies have a policy of ‘only employing the best people’. They then reward effort and skill generously and take considerable interest in each individual’s career path (eg appropriate training). Such encouragement develops a very positive corporate culture that pays off, particularly when the chips are down.

Channels Getting space on the shelf or floor of a busy, successful retailer is no mean feat. Place (or location) is one of the four Ps in any marketing strategy. Consider the success of home brands because of their built-in access to a distribution. Tupperware, Nutrimetics and Mary Kay Cosmetics have almost perfected this competitive advantage such that the cost of developing a sales force to compete with them is quite considerable. It should be no surprise that retailers like Coles and Woolworths wish to sell petrol or get into banking, insurance etc.

Externalities A competitive advantage generated externally is very valuable. Some examples of competitive advantages that disadvantage potential external competitors include import quotas, tariff protection, duties and lost tax credits. Regulations that give competitive advantages include those that involve the issuance of licences (eg media, airlines and mining), government subsidies (eg banks, corporations and farmers), and such things as lower environmental controls and sales tax exemptions. It should be noted also, however, that externalities are also risky competitive advantages since they can be as quickly taken away.



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Segmentation and differentiation Most industries are characterised in the medium-term by the absence of any true barriers to entry. To be successful, therefore, firms must either market to a particular niche or segment (eg Mercedes versus KIA or Great Wall cars), or try to persuade consumers that their product or service is better. This typically requires costly marketing strategies focusing on non-price aspects of the product (eg safety balloon in some cars, after-hours medical services) although price aspects also matter (eg bulk billing doctors).

Skills Previously acquired related experience and skills are undoubtedly of immense value to a firm. It takes time to move up the learning curve. Staff with unique technical or research skills, marketing and production experience and skills, can ensure that appropriate strategies and decisions are made, and know how likely pitfalls can be avoided. Firms may thus beat their competitors by employing such people or ensuring their staff get trained accordingly.

SWOT analysis SWOT (Strengths Weaknesses Opportunities Threats) analysis extends a SUCCESS analysis by not just focusing on current strengths. It focuses on the SBU’s current weaknesses as well. These strengths and weaknesses are then put into the context of the external environment and the future. Analysis of the SBU’s strengths and weaknesses means management can then focus on how to avoid threats (eg by devising strategies to ensure strengths are not lost through imitation) or the compounding of weaknesses. Alternatively, management can focus on the opportunities available to exploit existing strengths by extending them or by strategies to shore up the weaknesses identified.

Internal Strengths A distinctive competence?

Adequate financial resources?

Good competitive skills?

Well thought of by buyers?

An acknowledged market leader?

Well-conceived functional area strategies?

Access to economies of scale?

Insulated from strong competitive pressures?

Technology leader?

Cost advantages?

Competitive advantages?

Product innovation abilities?

Proven management?

Other?

Weaknesses No clear strategic direction?

A deteriorating competitive position?

Obsolete facilities?

Subpar profitability?

Lack of managerial depth or talent?

Missing any key skills of competencies?

Poor track record in implementing strategy?

Plagued with internal operating problems?

Vulnerable to competitive pressures?

Falling behind in research?

Too narrow a product line?

Weak market image?

Competitive disadvantages?

Below average marketing skills?

Unable to finance needed changes in strategy?

Other?



External Opportunities Serve additional customer groups?

Enter new markets or segments?

Expand product line to meet broader range of customer needs?

Diversify into related products?

Vertical integration?

Ability to move to better strategic group?

Complacency among rival firms?

Faster market growth?

Threats Likely entry of new competitors?

Rising sales of substitute products?

Slower market growth?

Adverse government policies?

Growing competitive pressures?

Vulnerability to recession and business cycle?

Growing bargaining power of customers or suppliers?

Changing buyer needs and tastes?

Adverse demographic changes?

Combining SWOT with analysis of the Product Life Cycle (PLC) suggests different managerial skills are needed at different times of the investment.

Stage in PLC Type of manager required

Prototype development Originator/Inventor

Startup and early growth Planner/Organiser

Accelerated expansion Developer/Implementer

Mature growth Administrator/Operator

Decline and divestment Successor/Reorganiser

Strategic matrices A range of matrices has been put forward by strategic theorists to aid project selection. The original matrix put forward by the Boston Consulting Group arose from the PIMS (Profit Impact of Market Strategy) studies undertaken by the General Electric Company in the early 1960s. They found accounting returns on investment significantly increased with market share. Expanding their market share results in cost savings due to economies of scale and curve effects.

Figure 2 — A strategic matrix

Market Share

High Low

Growth High Stars Problem children

Low Cash cows Dogs

See Figure 2. Cash cows are those products with large market shares and thus capable of producing substantial cash flows. This follows since they are entering the mature stage of the PLC. For these reasons, not only should further investment funds be starved from them, but the cash cows should be milked to finance those stars which need more funds to consolidate their high growth into a high market share. Dogs should be divested. Problem children should be carefully filtered into those that have potential versus those that are definitely bad.



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While other models have followed (eg Porter and McKinseys) to guide strategic decision making, they do have some problems. These include:

• an excessive reliance on accounting measures of performance which among other criticisms are one-period measures and relate to book values not market values

• an inappropriate linkage between the financing decision and investment decision by assuming capital rationing exists

• the subjective nature of classifying products or SBUs

• an arbitrary assessment of strategic risk differences.

Question D What is your organisation’s competitive advantage?

GUIDING PRINCIPLES FOR CASH FLOW ESTIMATION Once a strategic review has suggested a potentially positive net present value, then comes the difficult part of estimating the cash flows arising from such a capital investment.

Nothing is surer than our knowledge that many of our specific cash flow estimates will be wrong.

The techniques for appraising proposed capital investment projects are relatively straightforward in concept. The key issue relates to estimating the cash flows to which these techniques of appraisal are applied.

Guessing future cash flows can be split into three areas:

• Known variables — ones we can predict with quite a degree of certainty. They are fixed by law (eg the tax rate this year) or contract (eg office rent for the next two years) or driven by company policy (eg dividend policy or debt policy).

• Known unknown variables — most are like this in that we know they exist but are unsure of their exact value (eg prices beyond the current contract).

• Unknown unknown variables — ones that we never considered as likely relevant at the time of first planning (eg Asian currency crisis in 1998, pilots strike in Australia in the late 1980s, and the global financial crisis of 2008). All had quite substantial financial effects on some firms ‘but seemed to come from nowhere for many’.

Question E Can you identify some unknowns that have affected your organisation’s competitive advantage?



The cash flows which are pertinent for the purposes of capital budgeting are those which have yet to occur — expected cash flows — and therefore must be estimated. The validity of any investment decisions depends crucially on the robustness of these future cash flow estimates. Cash flows which occur before the decision date are referred to as ‘sunk costs’, and are not considered as relevant to the capital budgeting decision. Those cash flows which are important are the incremental cash flows: the difference in cash flows to the firm with the project and without the project. This truly measures the cash flows to the firm that the new project per se will generate.

Additionally, cash flows must be estimated on a post-tax basis. From the firm’s perspective, taxes are a cost of doing business like any other and must be treated accordingly.

The importance of accurate, well-researched cash flow estimates for the capital budgeting decision cannot be overstated. While no amount of accurate information and research can guarantee the future outcome of an investment project, poor information and research leads to poor decision-making.

Cash flow from assets (free cash flows) Our objective is to forecast free cash flow or cash flow from assets because we wish to evaluate if an investment is worthwhile independently of how it is financed.

Free cash flow (FCF) is the measure of cash flows free to satisfy investors. As a result, we can determine free cash flow in two ways. The first way focuses on the sources contributing to the size of the cash flow pie, while the second looks at how that pie is distributed.

Method 1 — Focusing on sources of the cash flow pie Operating cash flow (after tax)

– Additions to net working capital

– Capital spending Free cash flow

Method 2 — Focusing on distributions of the cash flow pie Interest after tax

– New debt principal Cash flow to debt holders

Dividends

– New equity + Cash flow to shareholders Free cash flow

There are three main principles for guiding a decision whether to include a specific cash flow or not in cash flow from assets.

Incremental (or with/without) principle This says that we should compare any and all cash flow effects on the firm as a result of the proposed capital expenditure.



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NOT Net CF to firm if venture accepted

BUT Net CF to firm Net CF to firm if venture – if venture accepted rejected

The implications of this principle are:

• Side effects such as reduced sales revenues of existing products should be included.

• Cash flows that exist irrespective of the capital expenditures (eg existing management overhead expenses and sunk costs) should be ignored.

Stand-alone principle Since it is too difficult to consider the entire effect on the firm of every capital expenditure, then we tend to treat each project like it was a project standing on its own, like a miniature firm. The implications of this principle are:

• Opportunity costs that are not direct cash flows should be included (eg using a vacant piece of land we already own because we could otherwise sell it or rent it out).

• Extra net working capital (ie extra current assets less non interest-bearing current liabilities) should be included. More inventory and receivables are needed to expand sales with new equipment. Extra net working capital should be included as an outflow when a project first begins, but as a cash inflow when the project winds up. For example, when a business is sold, the vendor gets cash for the stock as well as the fixed assets of the business.

• Salvage value at the end of the venture’s life should be included. Just as the cost of equipment is included as an outflow at the start, there is also a cash flow effect of the salvage value on wind-up. There may be tax effects from a profit/loss on sale as well.

The consistency principle This principle implies that we should treat alike cash flows the same way but not double count any. The implications of this principle are as follows:

• Taxes should be treated consistently in all cash flows. It would be incorrect to assess the tax on revenue without recording the tax benefit of various expenses incurred in earning that revenue. Similarly, the after tax return on investment calculated in any evaluation should be compared with an after tax overall cost of financing. Special attention is needed in relation to depreciation, investment or development allowances, profit or loss on asset disposal and dividend imputation effects.

• Inflation should be treated consistently. It is incorrect to estimate revenue increasing due to inflation without recording the inflation effects on various expenses. Similarly, an inflated return on investment should be compared with an overall cost of financing, including inflation.

• Financing charges should be treated consistently. It is incorrect to calculate a return on investment, based on cash flows net of financing charges, which is then compared with an overall cost of financing. This is an example of double counting. Therefore, all financing costs (eg dividends, interest, financial lease expenses) should be ignored for calculating cash flows for capital budgeting.



In summary, in calculating net cash flows, the following rules apply:

• use cash flows, not accounting income

• ignore sunk costs

• include opportunity costs

• include side effects

• include working capital

• include taxation

• ignore financing charges (interest and loan repayments).

COMMON CAPITAL BUDGETING ERRORS Error 1 — The wrong planning horizon Many firms have fixed capital budgeting horizons for planning and decision-making purposes. While three and five years are quite typical, firms in industries with long payoff schedules often have planning horizons of ten and even 20 years in the case of large scale mining ventures.

Clearly there is an argument for making the horizon as short as possible because that reduces potential forecast error. However, the counter argument is that we should plan for the period over which the venture is expected to produce cash flow benefits. Longer horizons for planning must therefore allow for this potential forecast error.

Error 2 — Double counting interest expense Because interest is a cash flow, many organisations mistakenly include this financing cash flow in determining free cash flow. This can be seen as double counting because the overall discount rate or cost of capital, as it is sometimes called, has already included the cost of financing the investment. To include it in the cash flows as well as the discount rate is double counting. Put another way, interest is one way free cash flows are distributed and should only be included if calculating free cash flow via method 2 above (a very unusual approach indeed). The result is that a business venture appears much worse than it would if the calculations were done correctly.

Error 3 — Inconsistent treatment of inflation This common error is also understandable. It arises because people do not like forecasting inflation so they decide to project cash flows in real terms — that is, without inflation. They then use the current discount rate or hurdle rate as their risk-adjusted required rate of return. However, the latter implicitly has an implied inflation rate in it. The result is that a business venture turns out much worse than it really should.



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QUANTITATIVE RISK MANAGEMENT TOOLS We have discussed how to estimate cash flows in capital budgeting, but those projected cash flows will not occur with certainty. There are several techniques which can provide some ideas of the risk level of a project, and this risk level is directly related to the uncertainty of the project’s cash flows. The following section discusses three techniques used to assess the risk level of the project: sensitivity analysis, scenario analysis and simulation (Monte Carlo) analysis.

Sensitivity analysis Decision-makers may require sensitivity (ie ‘what if?’) analyses be applied. For example, given the critical role of sales in any net present value, they may ask for ‘what if sales are 50 per cent of forecast?’

Scenario analysis Decision-makers may require applications be submitted under various scenarios. This involves estimating the cumulative effect on free cash flow if everything were to go as well as possible (ie best case scenario) and another if everything were to go as badly as possible (ie worst case scenario). Scenario analysis has a problem — it is unlikely that all the best things would happen simultaneously, just as it is most unlikely that all the worst things would simultaneously happen.

Simulation Decision-makers may require applications be submitted after incorporating Monte Carlo simulation. This technique requires much research and programming skill. Critical inputs are given probabilistic values (ie a distribution of possible values). Random values from each distribution are drawn. The analysis is simulated many times by computer. Errors are common to the untrained user.

An organisation can choose to (or have the option to) convert a known unknown into a known variable. Entering into a forward contract costs because fluctuations in foreign currency revenues are transferred. Options and insurance are examples of explicit transactions to have the option of converting a known unknown into a known variable, but these decisions can be expensive. Management needs evidence of the likely impact of future fluctuations to substantiate the expense of explicit risk reduction measures.

Question F Which approach does your organisation use to assess risk for major investments?



QUALITATIVE RISK MANAGEMENT TOOLS ‘Soft’ risk management tools are more implicit and therefore the cost of them is more difficult to measure. There is a range of other strategies an organisation can use to reduce the effect of an unexpected event such as foreign currency movements reducing revenues unexpectedly. For example, they could set up a natural hedge by borrowing funds to finance the project in the currency in which the revenues will later be denominated.

Other similar ideas reduce the impact of changes and include:

• acquiring staff with the complementary skills or services

• joint ventures, partnerships and strategic alliances

• concentrating on areas where the organisation has existing strengths (eg service stations now sell much more than petrol)

• ensuring the firm has more than one competitive advantage such that they are not exposed to threat if competitors imitate sooner than they thought (eg McDonalds do not just have a good marketing strategy aimed at several segments, they also have access to lower cost staff (eg teenagers and pensioners), economies of scale in production, training and unique locations of distribution (eg Russia, China, entertainment centres))

• utilising generalised off-the-shelf components rather than arranging for custom-made products to be developed

• producing product that is compatible with the dominant design paradigm (eg Windows compatible software such as Adobe).

Question G Identify a strategic alliance/partnership that your organisation has recently made.

MODULE REVIEW A financial evaluation of benefits and costs from investing in new capital equipment is just one of the steps in the capital budgeting process. While there are a number of common errors incurred in the quantitative evaluation stage, management is less likely to make them if the three guiding principles are applied (ie with/without, stand-alone and consistency principles).

Many projects fail to achieve forecasted benefits. While there is a range of reasons for this, one useful solution is to ensure cash flow predictions make intuitive sense and can be justified by a competitive advantage. Embedding capital budgeting in a wider strategic planning process pays off. However, even then we make forecast errors. An idea of their significance can be obtained through sensitivity, scenario and simulation analysis. In addition, other qualitative solutions can be explored (eg natural hedging).



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CHECKLIST Tick the boxes if you believe you have completed the following and are prepared for the next module.

Read textbook Chapter 8 and Chapter 9.

The article by D’Angelo Fisher (2016) discusses the key strategic issue of competitive advantage while the article by Kiefte (2011) looks at the issue of outsourcing, and highlights the need for a strategic imperative to underlie any such decision. Note the main issues raised.

Complete Q1–Q14 (on pp 271–273) of the textbook to help ensure your understanding of this module.

Ensure you’ve completed all the response boxes in Module 6.

Ensure you have achieved the Module 6 learning objectives.

Pre-read Module 7 notes and annotate brief answers to the questions for Module 7.



NOTES



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READINGS Note: All the readings are regularly reviewed for currency and relevance. Their inclusion is based on these factors, not on when they were written, in some cases several years ago.

Key readings Fisher L D, 2016, ‘The end of competitive advantage’, Acuity, Issue 22, June, pp 20–22.

Kiefte B, 2011, ‘journeys into outer space’, 82(3) Charter, April, pp 20–22.

Taplin C and Friedman M, 2015, ‘Increasing productivity in the face of unrelenting change’, 67 Governance Directions, pp 82–85.

Optional readings/background references Harnish V, 2012, ‘Competitive advantage — juggling six balls’, 83(1) Charter, February, p 40, http://connection.ebscohost.com/c/opinions/71870689/competitive-advantage-juggling-six-balls.

O’Shannassy T, 2008, ‘Sustainable competitive advantage or temporary competitive advantage: Improving understanding of an important strategy construct’, 1(2) Journal of Strategy and Management, pp 168–180.



NOTES



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Module 6

QUIZ Determine if the following statements are True or False.

Question 1 Each strategic business unit is more likely to succeed if:

(a) strategic planning is undertaken on an individual basis

True or False?

(b) strategic plans extend to at least between three to five years from the present

True or False?

Question 2 An organisation’s ‘Cash Flow’ or ‘Cash Budget’ refers to their forecast of all future cash inflows and outflows for capital budgeting purposes.

True or False?

Question 3 Management forecasts a new business will cost $400,000 and return cash flows excluding inflation of $250,000 per annum for two years. The current return, required on investments of this risk, is 17 per cent per annum. The latter includes five per cent per annum for expected inflation. In such a scenario, the net present value of this business is negative.

True or False?

Question 4 Michael Porter, the highest paid strategic consultant, maintains from basic economics that a positive NPV business venture can only occur for two reasons — namely if management can differentiate their product to customers or pursue niche segment customers.

True or False?

Question 5 BBL is an Australian company with Australian shareholders. It borrows 60 per cent of the funds each year to buy the assets of a business for $2 million. The terms are ten per cent per annum on a reducing balance loan over five years. The business generates revenues of $1 million per annum for each of the five years of the expected life of the plant and machinery. Cash operating expenses are 40 per cent of revenues. The appropriate hurdle rate for this investment is 20 per cent per annum. The NPV for this business venture is close to –$205,000.

True or False?



Question 6 In a SWOT analysis, the strengths and weaknesses focus primarily on the internal and historical aspects of the organisation. In contrast the opportunities and threats primarily relate to the future and external aspects of the organisation’s competitive position.

True or False?

Question 7 Strategic risk management tools differ from strategic assessment tools in that the former attempt to cope with the problems identified by the latter. An interest rate swap is an example of a soft or qualitative risk management tool.

True or False?

Question 8 Two retired academics have decided to set up their own business with their lump sum payouts. They both have an aversion to borrowing. After undertaking a SWOT analysis, they believe that their business profits will basically arise from an innovative idea for using the Internet for educational services. They expect competitors to imitate their idea within a year. However, the idea will cost only $200,000 to implement and is expected to yield $180,000 pa forever in net cash flows. If the opportunity cost is 15 per cent per annum, then the business will be worth $1.2 million in a year.

True or False?

Question 9 A firm with spare office space is considering expanding its product line and thus using the space for other staff for that new product. The spare office space is a wonderful bonus and is more likely to make the new product line have a positive NPV.

True or False?

Question 10 Interest paid is not a relevant cash flow for project evaluation.

True or False?

Module 6 COMPETITIVE ADVANTAGE - Windows advantage Governance Institute of Australia / 2017 6 – 1...

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