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Chapter 2 Market Imperfections and Value: Strategy Matters

Chapter 2 Market Imperfections and Value: Strategy Matters. DR. IBRAHEM AL-EZZEE-FIN421CHAPTER2. Strategy sets the general direction of the organization and provides the framework within which capital investment opportunities are sought .

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Chapter 2 Market Imperfections and Value: Strategy Matters

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  1. Chapter 2 Market Imperfections and Value:Strategy Matters DR. IBRAHEM AL-EZZEE-FIN421CHAPTER2

  2. Strategy sets the general direction of the organization and provides the framework within which capital investment opportunities are sought. • The major focus of strategy is the generation of wealth through creation and use of competitive advantage. • Competitive advantage is a departure from perfect competition that it makes it possible to earn an economic profit DR. IBRAHEM AL-EZZEE-FIN421CHAPTER2

  3. Perfect product or services markets have the following characteristics: • No restrictions on entry and exit • No producers so large that they have price influence • All producers manufacture identical products • All producers have identical cost • Complete information about competitors’ actions DR. IBRAHEM AL-EZZEE-FIN421CHAPTER2

  4. In a competitive environment business can just barely satisfy investors and earn an economic profit of zero. • Businesses can go beyond survival to create wealth if they can avoid significant aspects of market perfection. DR. IBRAHEM AL-EZZEE-FIN421CHAPTER2

  5. Competitive Advantage CA. Is a departure from perfect competition that makes it possible to earn an economic Profit. The key considerations necessary for competitive advantage are: a. Industry characteristics b. Product differentiation c. Cost advantage DR. IBRAHEM AL-EZZEE-FIN421CHAPTER2

  6. Industry Characteristics • Barriers to entry exist • Customers are not price sensitive • Customers are not fully informed • Demand is stable • Competitors are limited b. Product Differentiation • Features: special feature preferred by customers will make it possible to gain competitive advantage. • Quality: Example of Toyota and General Motors. • Image: Create image like consuming the product will make a Hero • Service • c. Cost Advantage DR. IBRAHEM AL-EZZEE-FIN421CHAPTER2

  7. Cost Advantage • Economies of scale • Technology • Corporate culture • Control of supply of inputs DR. IBRAHEM AL-EZZEE-FIN421CHAPTER2

  8. Strategic Planning The ultimate goals of strategic planning are competitive advantage and economic profit • The strategy of the company defines the business that the company is in and how it intends to position itself within the industry • Strategy Development: • A statement of goals • An analysis of the environment • An analysis of the organization itself DR. IBRAHEM AL-EZZEE-FIN421CHAPTER2

  9. Goals: Wealth maximization objective need to be translated into concrete goals against which performance can be measured( ROA, ROE or cost/unit) • Analysis of the Environment: Threats & Opportunities a. Threats: a threat is any unfavorable situation in the organization's environment that is potentially damaging to the organization and its Strategy. DR. IBRAHEM AL-EZZEE-FIN421CHAPTER2

  10. b. Opportunities: An opportunity is any favorable situation in the organization’s Environment that support the demand for a product or service and permits the firm to enhance its position. An understanding of the organization’s opportunities and threats help the strategist identify the company’s most effective niche. DR. IBRAHEM AL-EZZEE-FIN421CHAPTER2

  11. Analysis of the organization What are our strengths and weaknesses? a. Strengths: A strength is resource or Capacity the organization can use effectively to achieve its objectives b. Weaknesses: A weakness is a limitation, fault, or defect in the organization that will keep it from achieving its objectives DR. IBRAHEM AL-EZZEE-FIN421CHAPTER2

  12. Industry Analysis An industry can be defined as a group or groups of organizations producing similar or identical products. These organizations also compete for customers to purchase their products and must secure the necessary resources (or inputs) that are converted (or processed) into final products (or outputs). Porter’s Five Factors model (page46) DR. IBRAHEM AL-EZZEE-FIN421CHAPTER2

  13. Threat of new entries: Under what conditions will a new competitor enter a firm’s market. What can a firm do about it?. • Bargaining power of the buyers: In general, the higher the bargaining power of the industry’s buyers possess, the less the advantage the selling firm has. • Bargaining of the suppliers: In general, the greater the power the supplier has, the less advantage the firm has. DR. IBRAHEM AL-EZZEE-FIN421CHAPTER2

  14. Threat of substitutes : The closer the substitutes the more limited the power of the seller. • Rivalry among existing firms (intensity of rivalry): In general, • the more competitors, the greater the rivalry, and b. The more equivalent the firms are in terms of size, skills, and market power, the greater the rivalry tends to be. DR. IBRAHEM AL-EZZEE-FIN421CHAPTER2

  15. Aligning Capital Budgeting with Corporate Strategy: • Strategy is the foundation of a successful capital budgeting system • Strategy should guide decisions about where to look for CIO and which investments are most likely to have positive NPVs. • Successful capital budgeting and wealth maximization are therefore dependent on sound strategy. DR. IBRAHEM AL-EZZEE-FIN421CHAPTER2

  16. Capita Budgeting Pitfalls Bias against strategically important CIs a. Favoring replacement decisions b. Undue focus on short-term results (short payback period) c. A narrow or shortsighted view-ignoring the value of future IO that may be created by the investment currently under consideration. d. Investing in growth for growth’s sake. DR. IBRAHEM AL-EZZEE-FIN421CHAPTER2

  17. Failure to give up is another barrier to strategy implementation. • Allocating capital among divisions according to past profitability is another potential detriment. • Capital investment analysis ignoring market dynamics is another blow implementation of strategy. • Compensation system must be based on longer-term profitability. DR. IBRAHEM AL-EZZEE-FIN421CHAPTER2

  18. Financial Decisions and Strategy • Capital investment policy (CIP): CIP must be designed to assure that the investment chosen will contribute to the corporation’s strategy • Capital structure policy (CSP): Choosing the financing mix that will minimize the cost of capital and maximize the value of the business DR. IBRAHEM AL-EZZEE-FIN421CHAPTER2

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