Chapter 2
Market Imperfections and Value:
Strategy Matters
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
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
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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

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 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.
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 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
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a.
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
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Cost Advantage
 Economies of scale
 Technology
 Corporate culture
 Control of supply of inputs
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
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:
1.
A statement of goals
An analysis of the environment
An analysis of the organization itself
2.
3.
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
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.
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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.
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Analysis of the organization
What are our strengths and weaknesses?
a. Strengths: A strength is resource or Capacity
the organization can use
achieve its objectives
effectively to
b. Weaknesses: A weakness is a limitation,
fault, or defect in the organization that will
keep it from achieving its objectives
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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)
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
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.
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
Threat of substitutes : The closer
the
substitutes the more limited the power of the
seller.
Rivalry among existing firms (intensity of
rivalry): In general,
a. 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.

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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.
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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.
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
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 longerterm profitability.
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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
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