Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy

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Chapter 7 Investment strategy and process 175

IMPROVE

& DEFEND

(Selective

Investment)

IMPROVE

& DEFEND

(Selective

Investment)

HARVEST

OR DIVEST

HARVEST

OR DIVEST

HARVEST

OR DIVEST

INVEST

& GROW

INVEST

& GROW

INVEST

& GROW

LowMediumHigh

HighMediumLow

Market Attractiveness

Business Strength

IMPROVE

& DEFEND

(Selective

Investment)

Figure 7.1

McKinsey–GE portfolio

matrix

2 Where the market is somewhat less attractive and the business less competitive (the

diagonal unshaded boxes), the business strategy is to get the maximum out of exist-

ing resources. The financial strategy is therefore to maximise or maintain cash flows,

while incurring capital expenditures mainly of a replacement nature. Tight control

over costs and management of working capital lead to higher levels of profitability

and cash flow.

3 The remaining businesses have little strategic quality and may, in the longer term,

be run down or divested unless action can be taken to improve their attractiveness.

The Japanese art of performance

Ask any Japanese business exec-

utive which company he or she

considers a role model and the

chances are high they will name

General Electric.

While few companies in Japan

have come anywhere near match-

ing GE’s impressive record, Sanyo

Electric has been compared to the

US conglomerate for a distinctly

un-Japanese strategy: its habit of

rapidly ditching businesses that

fail to perform. The consumer

electronics maker has recently

transformed itself from an

industry also-ran, best known

for its low prices, to a technology

powerhouse focused on business-

es where it has leadership in glob-

al markets.

Sanyo is the world’s largest

maker of digital still cameras,

with a 30 per cent share of the

market. It leads the global mar-

ket in optical pick-ups – key com-

ponents of CD and DVD players –

with its 40 per cent share and

has the top share in some 40

types of semiconductor. Sanyo’s

rechargeable batteries dominate

the market and can be found in

half the world’s mobile phones.

Moreover, the company has had

a string of innovative hits in the

past few years. This transforma-

tion has contributed to a 21 per

cent rise in operating profits on

record sales. Yukinori Kuwano,

Sanyo’s chief executive, attributes

Sanyo’s recent success to its recent

efforts to be selective about where

it puts its resources. ‘Our main

aim (has been) to focus on products

that we are number one in global-

ly’, says a smiling Mr Kuwano.

‘Unless you choose what to focus

on you will not be able to survive.’

Sanyo has adopted a system

that rates its businesses according

Continued

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176 Part II Investment decisions and strategies

High

HighLow

Low

‘STARS’

‘CASH

COWS’

‘QUESTION

MARKS’

‘DOGS’

Divest

Relative Market Share

Market Growth

Figure 7.2

Normal progression of

product over time

An alternative is the Boston Consulting Group approach, which describes the busi-

ness portfolio in terms of relative market share and rate of growth (see Figure 7.2). This

matrix identifies four product markets within which a firm may operate: (1) ‘stars’

(high market share, high market growth), (2) ‘cash cows’ (high market share, low mar-

ket growth), (3) ‘question marks’ (low market share, high market growth) and (4) ‘dogs’

(low market share, low market growth). The normal progression starts with the poten-

tially successful product (‘question mark’) and moves in an anticlockwise direction,

eventually to be withdrawn (divested).

From this strategic analysis of the firm’s business portfolio, we suggest the pattern

of resource allocation outlined in Figure 7.3. Businesses offering high growth and the

possibility of acquiring market dominance are the main areas of investment (‘stars’

and ‘question marks’). Once such dominance is achieved, the growth rate declines and

investment is necessary only to maintain market share. These ‘cash cows’ become gen-

erators of funds for other growth areas. Business areas that have failed to achieve a

sizeable share of the market during their growth phase (‘dogs’) become candidates for

divestment and should be evaluated accordingly. Any cash so generated should be

applied to high-growth sectors.

Having developed its investment strategy, management can assess how individual

projects fit into the firm’s long-term strategic plan. Project appraisal – or, in the case of

capital shortage, project ranking – is not only judged according to rates of return.

Boston Consulting Group

approach

An approach for assessing capi-

tal proposals based on the mar-

ket growth and market share of

the products relating to the

proposal

to margins and growth potential.

Those offering low margins and

low growth prospects become

candidates for weeding out. ‘It’s

easy to say “concentrate and

select”, but you need a standard

for doing so,’ says Mr Kuwano.

Once a business is identified as

a ‘loser’ managers go through a

lengthy process of debate about

what to do with it. When, for

instance, Sanyo decided it had to

do something about a loss-making

vending machine business that

was number two in its market,

managers considered several

options, including an acquisition

of one of its rivals, before deciding

to sell the business to its leading

competitor.

At the same time Sanyo led the

market in rechargeable batteries.

Since this was a promising sector

it decided to bolster its position by

acquiring Nippon Batteries’ lithi-

um ion battery business and

Toshiba’s nickel metal hydride

business. Sanyo has thus managed

to streamline its businesses rela-

tively quickly while ensuring staff

clearly understand the rationale

behind the decisions.

Critics point out that Sanyo

still has much work to do on its

lossmaking white-goods business.

If it can build a white-goods busi-

ness with a strong global pres-

ence, Sanyo will have achieved a

feat that so far even GE has failed

to pull off.

Source: Michiyo Nakamoto, Financial Times,

18 May 2004, p. 12.

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Chapter 7 Investment strategy and process 177

Many companies will reject projects offering high returns because projects fall outside

strategic thinking. Ultimately, the capital budget must tie up with corporate strategy

so that each project contributes to an element of that strategy.

In Chapter 4, we introduced Shareholder Value Analysis (SVA) as a valuable planning

tool and guide for strategic decision making. It is basically an extension of the NPV

approach where the focus is on business units, strategies and financial goals. A business

is viewed as a portfolio of investment projects, but the emphasis is placed on maximising

the value of strategic business units, not merely that of the capital projects within them.

Rather than dwell on short-term measures, such as annual earnings per share or

return on capital, SVA manages cash flows over time. It is this long-term cash flow that

determines the long-term value of the business. The value of adopting a new strategy

is assessed in terms of the difference in the value of the business before and after

implementation.

Self-assessment activity 7.1

Why is it important to view capital budgeting within a strategic framework?

(Answer in Appendix A at the back of the book)

High

HighLow

Low

‘STARS’

(Invest)

‘CASH COWS’

(Funds Source)

‘QUESTION

MARKS’

(Invest)

‘DOGS’

Divest

(Source of funds)

Relative Market Share

Market Growth

Figure 7.3

Investment strategy

Corporate mortality at Microsoft

Bill Gates is the world’s richest man and head of Microsoft, arguably the world’s most success-

ful company. Yet he is brutally aware of his company’s vulnerability, even when most people

regard the business as an indomitable near monopolist at the heart of the software industry. As

he said recently: ‘Someday Microsoft will go out of business, it’s only a matter of time. Will it

happen in my lifetime, while I am still deeply involved in the company? I hope not. I wake up

every day working hard to reduce the probability of this. Companies are mortal’ (Bennet, 2001).

Gates realises that it is this awareness of corporate mortality that forces the company to

continue its punishing innovation cycle.

Over the years, there has been talk that Microsoft will use its vast cash resources and mar-

ket capitalisation to diversify into other industries such as banking and telecoms. Gates rejects

this. So why has it been so successful? Of course, at one level, the main reason is its ability to

innovate and keep ahead of the competition. But Gates explains why the company has the

highest market capitalisation in terms of its high-volume, low-cost products.

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178 Part II Investment decisions and strategies

■ Project finance

Large-scale strategic projects, such as the construction of tunnels, roads and power sta-

tions, are often funded through project finance. Here the operation is financed and con-

trolled separately from the operations of the constructor or user. The obvious benefit to

the company is that creditors of the project only have claims on the project’s cash flows,

not those of the companies involved in the construction process. Following the Private

Finance Initiative (PFI), which was introduced in the UK in 1992, many public sector

projects have been funded in this manner.

7.3 ADVANCED MANUFACTURING TECHNOLOGY (AMT) INVESTMENT

An area where strategic decision-making is often required is the evaluation of advanced

manufacturing technology projects. Strategic investment appraisal links corporate

strategy to the costs and benefits associated with AMT and other strategic decisions.

Frequently, it is insufficient to consider only financial issues; many of the benefits are

less tangible and hard to quantify.

The past 20 years have seen growth in new technology capital projects, creating dif-

ferent problems for the decision-maker. AMT projects offer a range of less tangible bene-

fits: for example, greater flexibility with reduced ‘downtime’ on production changeover.

Greater flexibility enables businesses to meet the challenge of increasing competition,

shorter product life cycles and satisfying customers’ specific requirements. AMT offers a

flexible manufacturing system (FMS), in which a sequence of production operations are

computer-controlled to respond to ever-changing production and design requirements.

AMT example: Foster Engineering Ltd

Foster Engineering Ltd is considering introducing a flexible manufacturing system (FMS)

to modernise production in a department currently using conventional metal-working

machinery. The declining market and the awareness that its main competitors have

recently introduced new technology have made the need to modernise plant facilities an

urgent priority.

An AMT proposal has been put forward, offering an FMS capable of producing the

present output. It involves two machining centres with CNC lathes, a conveyor system for

AMT terminology

AMT investment helps companies achieve competitive advantage through a number of

technologies:

■ Computer-aided design (CAD) helps the engineer test and modify a design from any

viewpoint.

■ Computer-integrated manufacture (CIM) brings together the manufacturing process and

the computer.

■ Computer-numerically controlled (CNC) machines can be easily reprogrammed to

perform different tasks.

■ Flexible manufacturing systems (FMS) enable the firm to produce a far greater variety of

components quickly.

■ Direct numerical control (DNC) systems connect a number of numerically controlled

machines by computer.

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Chapter 7 Investment strategy and process 179

transferring components and a computer for scheduling, tooling and overall control. The

total investment would cost £2.4 million, half being incurred at the start and the other

half after one year, at which point the existing machinery could be sold for £50,000. Any

benefit would arise from Year 2 onwards for five years. The two quantified benefits are

as follows:

1 A reduction in the number of skilled workers from 50 to 15. The annual cost of a skilled

worker is £20,000 (savings of 35  £20,000 = £700,000 p.a.).

2 Savings in scrap and re-work of £50,000 p.a.

The company requires all projects to offer a positive net present value discounted at

15 per cent.

The accountant produces the following evaluation showing that the FMS proposal has a

negative NPV of £159,000 and fails to meet corporate investment criteria:

FMS proposal

Annual benefit (£000)

PV at Year 1

2,346

PV at Year 0

2,041

Initial investment

Year 0

Year 1 (2,200)

NPV (159)

1£1,00021£1,200  502  0.87

1£1,2002

£2,346  0.87

£2,346  PVIF

115%, 1 yr2

£700,000  3.352

£700,000  PVIFA

115%, 5 yrs2

An incensed production engineer in Foster Engineering, on hearing that the proposal is

unacceptable, points to the ‘intangible’ benefits that the FMS will offer:

■ Improved quality leading to a significant, but unknown, reduction in sales returns

through faulty workmanship.

■ Reduced stock and work-in-progress, enabling improved shopfloor layout, greater space

and a lower working capital requirement.

■ Lower total manufacturing time, enabling the company to respond more quickly to cus-

tomer orders and to reduce work-in-progress further.

■ Significantly improved machine utilisation rates, although the actual degree of improve-

ment is difficult to quantify.

■ Increased capacity with the option to operate unmanned night workings.

■ Greater flexibility, enabling shorter production runs and faster re-tooling and

re-scheduling.

CIM involves the computerisation of functions and their integration into a system

that regulates the manufacturing process. It brings together the individual manufac-

turing techniques referred to earlier under unified computer control.

Many of these benefits could be quantified, at least in part (e.g. the savings in work-

ing capital), although the degree of confidence in the underlying assumptions may not

be high. But even so, there will still be a large intangible element that cannot be quan-

tified. This has led to the charge that conventional methods of investment appraisal

are biased against AMT investments.

Kaplan (1986) raises the question of whether AMT projects must be ‘justified by

faith alone’. Should managers in Foster Engineering replace the DCF approach with a

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180 Part II Investment decisions and strategies

7.4 ENVIRONMENTAL ASPECTS OF INVESTMENT

Can firms afford not to invest?

Henry Ford once claimed: ‘If you need a new machine and don’t buy it, you pay for it without

getting it.’ The price paid is the loss in competitiveness from not taking advantage of new

technology.

In evaluating proposed investments, managers have turned increasingly to sophisticated

techniques. Their goal has been greater rationality in making investment decisions, yet their

accomplishment has often been quite different – serious under-investment in the capital stock

(the productive capacity, technology and worker skills) on which their companies rest. As a

result, they have unintentionally jeopardised their companies’ futures.

Ingersoll Milling Machine Company took a strategic view that it needed to invest in the lat-

est technology. Each production department manager annually had to write a justification to

keep any machine that was over seven years old. The only generally accepted reason for not

replacing equipment was that a new machine did not offer any significant improvements over

older models.

Much like AMT investment, many environmental capital projects have substantial costs

or benefits which may not be wholly reflected in conventional net present value analy-

sis. It should be recalled, from Chapter 1, that shareholders are not the only stakehold-

ers in the company and the needs of other stakeholders, including the wider community,

should also be incorporated into decisions. Environmental considerations have many

dimensions, including economic, political, technological and social.

Pollution issues will be covered by legislation and regulation, but often the direc-

tors will want to go beyond the statutory requirements. While costs are not difficult to

determine, the benefits are harder to quantify. For example, a greater sense of social

responsibility may be costly but could have long-term benefits if the enhanced corpo-

rate image results in more business and improved shareholder value.

The steps involved in evaluating projects with environmental implications are:

1 Evaluate the projects using conventional capital appraisal methods.

2 Identify and incorporate statutory environmental costs as part of the evaluation.

3 Assess the costs and benefits of other environmental measures. For example, intro-

ducing anti-pollution measures should help reduce compensation claims.

belief that AMT is the key to the future and that strategic positioning must override

economic analysis?

The answer is not to dismiss DCF analysis, but to see it within a wider strategic con-

text. We advocate a three-stage approach to analysing AMT capital projects:

1 Does the project fit well within the company’s overall corporate strategy?

2 Does the DCF analysis, based on the quantifiable elements of the decision, justify

the investment outlay?

3 Where the net present value calculated in stage 2 is negative, examine the shortfall.

Does management believe that the ‘value’ of the intangible benefits exceeds the

shortfall? This last stage is essentially a subjective process whereby managers con-

sider the strategic and operational benefits. No one can put an accurate value on

flexibility, for example, but it would be wrong to exclude such a major benefit from

consideration in the decision process.

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Chapter 7 Investment strategy and process 181

Does Shell take the longer view?

The Royal Dutch Shell group operates in 140 countries and invests over £8 billion annually in

oil exploration, refining and other capital projects. Most of its capital projects have sustainable

environmental implications.

Take a look at Shell’s annual report (www.shell.com) to examine the level of environmental

capital investment and provisions for cost of decommissioning and site restoration. What is its

policy on environmental investment and sustainable development? To what extent does Shell

take a long-term view on investment and consider wider social and environmental aspects?

4 Specify the internal controls to be introduced to ensure that pollution, etc., is min-

imised during construction and implementation.

5 Assess the impact of the decision on shareholder wealth, ethical and social respon-

sibility goals.

7.5 THE CAPITAL INVESTMENT PROCESS

So far we have focused on investment appraisal. Similar emphasis is found in much of

the capital budgeting literature, the assumption being that application of theoretically

correct methods leads to optimal investment selection and, hence, maximises share-

holders’ wealth. The decision-maker is viewed as having a passive role, acting more as

a technician than as an entrepreneur. Somehow, investment ideas come to the surface;

various assumptions and cash flow estimates are made; and risk is incorporated with-

in the discounting formula to produce the project’s net present value. If this is positive,

the proposal becomes part of the admissible set of investment possibilities. This set is

then further refined by the evaluation of mutually exclusive projects and the appraisal

of projects under capital rationing, where appropriate.

Mattel boss wants you to be a Barbie girl in a Barbie world

Not many grown men will admit to playing with

dolls. For Robert Eckert, chairman and chief exec-

utive of Mattel, it is a daily activity. But then Mr

Eckert has been trying to develop ways of keep-

ing his brands fresh instead of diversifying into

new ones.

It is a sign that Mattel is keeping up with the

times. This month, the world’s biggest toy compa-

ny is gearing up to launch its latest Barbie doll.

The Multi-Ethnic Barbie is the most politically

correct doll to be launched yet and comes at a

sensitive time for the US following the war in

Afghanistan. Barbie is set to feature in Barbie as

Rapunzel, her second animated feature film, in the

hope of repeating the success of last year’s Barbie

in the Nutcracker. The film earned Barbie more

than $150 million in video sales, dolls and other

related merchandise last year.

When Eckert arrived at the helm last year, Mattel

had been struggling with poor earnings, senior

management defections and the botched acquisi-

tion of the Learning Company, a software group.

Eckert says, ‘But every time Mattel has strayed

from toys, it has done poorly. We are a toy brand,

that is what we know and that is our business’.

Mattel’s shareholders find it difficult to argue

against this strategy. Like Mr Eckert, the business

unit managers are on performance-related incen-

tive schemes, all of which are linked to stock. ‘If

the company does well, we all do well. Otherwise

we don’t,’ he says.

Source: Based on Lina Saigol, Financial Times, 15 February 2002.

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182 Part II Investment decisions and strategies

Inherent in this approach to capital budgeting are the following assumptions, few

of which bear much relevance to the world of business:

1 Investment ideas simply emerge and land on the manager’s desk.

2 Projects can be viewed in isolation, i.e. projects are not interdependent.

3 Risk can be fully incorporated within the net present value framework.

4 Non-quantifiable or intangible investment considerations are unimportant.

5 Cash flow estimates are free from bias.

Increasingly, it has become apparent that the emphasis on investment appraisal

rather than on the whole capital investment process is misplaced and will not neces-

sarily produce the most desirable investment programme. Investment decision-making

could be improved significantly if the emphasis were placed on asking the appropri-

ate strategic question rather than on increasing the sophistication of measurement

techniques. Managers need to re-evaluate the investment procedures within their

organisations, not to determine whether they are aesthetically and theoretically cor-

rect, but to determine whether they allow managers to make better decisions.

Capital budgeting may best be understood as a process with a number of distinct

stages. Decision-making is an incremental activity, involving many people throughout the

organisational hierarchy, over an extended period of time. While senior management may

retain final approval, actual decisions are effectively taken much earlier at a lower level,

by a process that is still not entirely clear and that is not the same in all organisations.

Figure 7.4 shows the key stages in the capital budgeting process. The primary aim

of such a process is to ensure that available capital resources are distributed to wealth-

creating capital projects that make the best contribution to corporate goals. A second

goal is to see that good investment ideas are not held back and that poor or ill-defined

proposals are rejected or further refined. We shall explore the following four stages:

1 Determination of the budget.

2 Search for, and development of, projects.

3 Evaluation and authorisation.

4 Monitoring and control.

■ Determination of the budget

In theory at least, all capital projects could be put to the capital market for funding

(individually or collectively as investment programmes), the availability of funds for

projects and rate of return required being a function of the market’s perception of the

prospective returns and associated risks. In practice, multi-divisional organisations

operate an internal capital market in which senior management is better informed than

the external capital market to assess capital proposals and allocate scarce resources.

If the investment decision-making body is a sub-unit of a larger group, the budget

may be more or less rigidly imposed on it from above. However, for quasi-autonomous

centres (divisions of larger groups with capital-raising powers) and/or independent

units, the amount to be spent on capital projects is largely under their control, subject,

of course, to considerations of corporate control and gearing.

■ Search for, and development of, projects

Economic theory views investment as the interaction of the supply of capital and the

flow of investment opportunities. It would be wrong, however, to assume that there is

a continuous flow of investment ideas. In general, the earlier an investment opportunity

is identified, the greater is the scope for reward.

Possibly the most important role which top management can play in the capital

investment process is to cultivate a corporate culture that encourages managers to

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Chapter 7 Investment strategy and process 183

Determination of the budget

– how much is available to spend?

Search and development

– what project ideas have emerged? (search)

– what costs and benefits will they generate? (screening)

– what type of project? (definition)

Evaluation

– what is the value of the projected costs and benefits?

– what is the target rate of return?

– does the project’s IRR exceed this?

(or does it have a positive NPV?)

– how risky is the project?

Authorisation

Monitoring and control

during implementation

– is the project on schedule?

– will costs exceed the budget?

ongoing

– is the project performing to budget?

post-auditing

– is the project performing to initial expectations?

– what lessons can we draw to assist future

appraisals?

Figure 7.4

A simple capital

budgeting system

search for, identify and sponsor investment ideas. Questions to be asked at the identi-

fication stage include the following:

1 How are project proposals initiated?

2 At what level are projects typically generated?

3 Is there a formal process for submitting ideas?

4 Is there an incentive scheme for identifying good project ideas?

Generating investment ideas involves considerable effort, time and personal risk

on the part of the proposer. Any manager who has experienced the frustration of hav-

ing an investment proposal dismissed, or an accepted proposal fail, is likely to develop

an inbuilt resistance to creating further proposals unless the organisation culture

and rewards are conducive to such activity. There is some evidence (Larcker, 1983)

that firms adopting long-term incentive plans tend to increase their level of capital

investment.

For the identification phase of non-routine capital budgeting decisions, especially

those of a more strategic nature, to be productive, managers need to conduct environ-

mental scanning, gathering information that is largely externally oriented. We should

not expect the formal information system within most organisations, which is set up

to help control short-term performance, to be particularly helpful in identifying non-

routine investment ideas.

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184 Part II Investment decisions and strategies

Preliminary screening

At this early stage, a preliminary screening of all investment ideas is usually conducted.

It is neither feasible nor desirable to conduct a full-scale evaluation of each investment

idea. The screening process is an important means of filtering out projects not thought

worthy of further investigation. Ideas may not fit with strategic thinking, or may fall

outside business units designated for growth or maintenance.

Screening proposals address such questions as the following:

1 Is the investment opportunity compatible with corporate strategy? Does it fall with-

in a section of the business designated for growth, maintenance or divestment?

2 Are the resources required by the project available (expertise, finance, etc.)?

3 Is the idea technically feasible?

4 What evidence is there to suggest that it is likely to provide an acceptable return?

5 Are the risks involved acceptable?

As the quality of data used at the screening stage is generally poor, it makes little sense

to apply sophisticated financial analysis. Accordingly, the simple payback method is

frequently used at this stage because it offers a crude assessment of project profitability

and risk.

Project definition

Any investment proposal is vague and shapeless until it has been properly defined. At

the definition stage of the capital investment process, detailed specification of the

investment proposal involves the collection of data describing its technical and eco-

nomic characteristics. For each proposal, a number of alternative options should be

generated, defined and, subsequently, appraised in order to create the project offering

the most attractive financial characteristics.

Even at this early stage, proposals are gaining commitment. The very act of collect-

ing information necessitates communicating with managers who may either lend sup-

port or seek to undermine the proposal. The danger is that, in this process, commitments

are accumulated such that investment becomes almost inevitable. The amount of

information gathered for evaluation is largely determined by the following:

■ The data perceived as desirable to gain a favourable decision.

■ The ease and cost of its development.

■ The extent to which the proposer will be held responsible for later performance

related to the data.

Top management should seek to ensure that the most suitable projects are submitted

by managers through establishing mechanisms that induce behaviour congruence. The

accounting information system, reward system and capital budgeting procedures should

all encourage managers to put forward the proposals that top management is looking

for. For many firms, however, the accounting information system and reward mecha-

nism encourage divisional managers to promote their own interests at the expense of

those of the organisation, and to emphasise short-term profit performance at the

expense of the longer term. Capital budgeting then becomes a ‘game’, with the account-

ing and reward systems as its rules. Cash flow estimates are biased to maximise the

gains to individuals within such rules.

Self-assessment activity 7.2

Outline the important stages in the capital budgeting process.

(Answer in Appendix A at the back of the book)

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