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BPS Exam II
BPS Exam II Review
| Term | Definition |
|---|---|
| Diversification | the expansion of operations by entering new businesses or product lines |
| Diversification in finance or investment portfolio management is used primarily as a: | risk-management techinque |
| In Corporate Strategy, Diversification can be a means of ________________ for shareholders | creating value |
| Reasons to Diversify | • Value creating: achieve economies of scope, increase market power, achieve financial economies • Value neutral: regulatory, low performance, risk reduction • Value reducting: managerial self-interest |
| Corporate-Level Strategy focuses on | building value by managing operations in multiple businesses |
| Corporate-Level Strategy address two issues: | 1. What businesses should a corporation participate in? 2. Can the corporation add value to its business units (and how)? |
| The ”Better Off” Test: | Are the parent and business unit better off together or apart? |
| Costs of Parental Ownership | • Allocation of corporate overhead (headquarters staff) • Imposition of inappropriate policies or services • Inefficient approval process for significant decisions • Bureaucracy • Conflict of goals |
| Because parental ownership imposes costs on its subsidiaries, we need to find ways in which parental ownership also _____________ | adds value |
| The Value Creation Toolkit | • Sharing resources • Market power • Corporate parenting • Portfolio management • Restructuring |
| Horizontal Diversification: | Similar Businesses |
| Vertical Integration or Vertical Diversification: | Expanding the Value Chain |
| Unrelated Diversification: | Dissimilar Businesses - constructive corporate parenting |
| Related Diversification: | • Sharing of resources • Increased market power |
| Economies of scope: | reduction in unit costs that results from spreading a fixed cost over a wider variety of products |
| Economies of scale: | reduction in unit costs that results from spreading a fixed cost over a greater volume of one product |
| Sharing a resource / capability can: | confer value to different business units that is especially valuable or difficult to replicate |
| Market Power | refers to the ability of a firm to influence market level of prices |
| Greater market (negotiating) power enables an enterprise to: | • Charge customer prices above the existing competitive level; i.e., reduce buyer power • Reduce costs of primary and support activities (or inputs) below existing competitive level; i.e., reduce supplier power |
| How to Achieve Market Power | • Scale (size), which leads to: Increased bargaining power over customers OR suppliers • Vertical diversification/integration – Backward (production of own inputs) – Forward (capture of distribution |
| Constructive Corporate Parenting (aka, “Financial Economies”) | • Providing efficient and effective management practices and strategies • Efficient capital allocation / portfolio management • Restructuring |
| Three key aspects to portfolio management: | – Assess competitive position of each business – Suggest strategic alternatives for each business – Allocate resources across the businesses |
| Key purpose of portfolio management: | – Achieve a balanced portfolio of businesses – That is, businesses whose profitability, growth, and cash flow complement each other |
| Asset Restructuring | • Sale of unproductive assets or business units • Acquisitions to strengthen core businesses |
| Capital restructuring | • Parent may have access to cheaper capital |
| Management restructuring | • Change business unit management teams • Tighten financial controls and reward systems for business units |
| Value Reducing Diversification | • Senior executives may pursue diversification out of self interest • Good corporate governance may limit management tendencies to over diversify |
| How to Diversify | • Build: Organic growth, "DIY" (do it yourself) • Borrow: Outsource capabilities through contracts; partnerships • Buy: Mergers & Acquisitions |
| Merger | – Two firms agree to integrate operations on relative co-equal basis – True mergers are relatively rare |
| Acquisition | – One firm buys a controlling, or 100%, interest in another firm with intent of making the target a subsidiary – More common than mergers or takeovers |
| Takeover | – Unfriendly acquisition – Target company has not solicited the acquiring firm’s bid |
| Why Do M&A Deals Fail? | – The business case does not make sense – The acquiring company pays too much – Execution problems destroy value |
| Horizontal acquisition | – Acquisition of a target in the same industry as the acquiring firm – Exploit cost and revenue synergies |
| Vertical acquisition | – Acquisition of a supplier OR a distributor of the acquiring firm’s products – Increased market power comes from capturing additional parts of the value chain |
| Related acquisition | – Acquisition of target in a highly related industry – Exploit cost and revenue synergies |
| M&A Deals: The Three Important Questions | – Does the deal make sense? – Do the economics work? – Can we execute |
| Synergy | the increase in value created by combining two units, as measured in comparison to the independent value of the units |
| Synergies take the form of: | – Revenue enhancements – Cost reductions: reduce overlapping employees or resources, achieve economies of scale or scope |
| Revenue Synergies | • Sharing of resources - cross sell products through common sales force - sharing of IP, R&D, distribution channels, etc. • Increased Market Power (over Buyers) |
| Cost Synergies | • Elimination of cost overlaps • Increased Market Power (over Suppliers) |
| Private Synergy | When the combination of assets of the acquirer and the target yields unique capabilities and core competencies that could not be achieved by another acquirer |
| Premiums | • Acquiring firms typically pay a premium over the prevailing value of the target firm; known as a “control premium” – Control premiums typically range from 20% - 60% • Justification for paying a control premium |
| Two Common Approaches to Valuation | •Comparable-Firm-Multiples, also known as: - Comparables approach - Multiples approach - Market-based approach • Discounted Cash Flow ("DCF") Analysis |
| Types of Multiples | • Peer multiples - Based on prevailing values of comparable firms - Just look at current stock price multiples for competitors • Transaction multiples – Based on past – Transaction multiples tend to be higher than peer multiples due to premiums |
| Discounted Cash Flow Analysis | • Projected future cash flows broken into two parts: - Forecast period, typically 5-10 yrs • Equity value equals sum of PV of the forecast period and PV of the terminal value - Common for terminal value to represent large portion of enterprise value |
| Two Types of DCF Analysis | • Stand alone (no synergies) – Estimate the target’s free cash flows without economic benefits of merger • With synergies – Cash flow forecast is adjusted to include both revenue enhancements and cost reductions |
| Inadequate Evaluation of Target | • Failure to complete effective due diligence can result in an excessive premium • Due diligence is often relaxed during bull markets • Managerial issues |
| Integration Difficulties | • M&A transactions are typically tough on employees • M&A can also create uncertainty for customers |
| Too much diversification can: | • Make it more difficult for managers and boards of directors to understand the business • over-reliance on financial controls at the expense of strategic goals • contribute to a focus on short term results |
| Financial controls: | targets for objective performance measures like ROE, net income |
| Strategic controls: | targets for qualitative and market – related metrics of performance related to strategy, such as market share, new product development, etc. |
| Corporate Governance: | a system for managing relationships among stakeholders in an organization to determine and control: – Strategic Direction – Performance |
| Shareholder Theory (the “Friedman Doctrine”/”Shareholder Primacy”) | responsibility of businesses is to maximize the financial return to shareholders (investors) – Businesses have no direct responsibility to other stakeholders, such as members of the community or special interest groups |
| Stakeholder Theory | • Businesses have an ethical responsibility to take into account the interests of all stakeholders, not just shareholders • Satisfying this ethical responsibility is an imperative even if it reduces shareholder returns |
| Separation of Ownership and Management | • For publicly-held companies in the U.S., ownership and control are separated: – Ownership is held by investors (principals) – Control (and decision making) is held by executives/managers (agents) |
| A ____________________________ exists between owners and managers | principal / agent relationship |
| Agency problem | The potential exists for a conflict of interest between the principal and the agent (when the agent acts in their own interest despite being paid to act on behalf of the principal) |
| In general, shareholders prefer: | riskier strategies and more focused (i.e., related) diversification – Can diversify their own risk – Over-diversification by managers can: • limit managerial interest in focused risk taking • make managing the expanded enterprise more difficult |
| Managers may prefer: | broader diversification and less risk (higher compensation and greater job security) |
| Managerial Opportunism: | seeking of self-interest with guile (cunning or deceit) |
| agency costs: | • Incentive Costs • Monitoring Costs • Enforcement Costs • Individual financial losses |
| Primary objective of corporate governance: | Ensure that the interests of top-level managers interests align with interests of other stakeholders, especially shareholders |
| Internal Mechanisms of Corporate Governance | • Ownership Concentration • Board of Directors • Executive Compensation |
| External Mechanisms of Corporate Governance | • Market for Corporate Control |
| Ownership Concentration | the number of large-block shareholders and the total percentage of the firm they own |
| Large-block shareholder | shareholder that owns at least 5% of a company’s issued shares |
| Board of Directors | a body of elected or appointed members who jointly oversee the activities of a company or organization |
| Selected Key Responsibilities of the Board of Directors | • Oversee CEO (hire/fire, set goals and compensation) • Review and Approve strategy • Financial Oversight • Board Governance |
| Executive Directors (“Insiders”) - of BOD | • Directors who are employees of the company • Typically includes the CEO • May include the CFO or other senior executives |
| Nonexecutive Directors (“Outsiders”) - of BOD | • Directors who are not employees of the company • “Related Outsiders” have a material relationship with the company • “Independent Directors” are Outsiders who have no material relationship with the company |
| NYSE Requirements | • Boards for NYSE-listed companies must consist of a majority of Independent Directors • The Board Audit Committee must consist entirely of outside independent directors |
| Activist investors: | intentionally seek underperforming companies |
| Sustainable development: | development that meets the needs of the present without compromising the ability of future generations to meet their own needs |
| Forces for Business Sustainability | • Heightened investor scrutiny • Employee expectations • Consumer interest and expectations • Politicians and NGOs (e.g. United Nations Programs) • Media coverage of business’s sustainability efforts |
| ESG (Environmental, Social and Governance) Investing | considers a company’s impact on the environment, its stakeholders (not just shareholders) and the quality of governance |
| Sustainable Finance | refers to the process of taking ESG considerations into account when making investment decisions in the financial sector, leading to sustainable economic growth |
| United Nations Sustainability Programs | • Principles for Responsible Investment (PRI): Calls for investors to weigh ESG principles in making investment decisions • Sustainable Development Goals (SDG): 17 macro goals related to ending poverty, improving health and education, etc... |
| The Paris Agreement (2015) | to address dangerous global climate change |
| Rationale for Sustainable Development | • The moral case: “it is the right thing to do” - We all have a responsibility to people and the planet, not just profit maximization • The business case: sustainable development can lead to longer term profit maximization |
| The Business Case for Sustainability | • Revenue Growth: allignment w/ customer preferences and new product development • Lower Costs: more efficiency • Increased Productivity: employee moral and engagement, talent recruitment |
| Potential Issues with Sustainability | • Revenue Growth: uncertainty associated w/ new products • Lower Costs: lack of certainty w/ cost reduction (timelines/payback horizons) • Increased Productivity: difficult to measure ROI |
| Basic Benefits of International Expansion | • Increased market size: Opportunity for revenue growth; Extend product life cycle • Economies of scale and learning: Leverage acquired expertise in new markets • Location advantages: Access to low-cost labor, energy, other resources + close w/ customer |
| Political Risks of International Expansion | – Instability in national governments – War, both civil and international – Limited, or no, rule of law – Potential nationalization of a firm’s resources |
| Economic Risks of International Expansion | – Differences and fluctuations in the value of different currencies – Differences in prevailing wage rates – Difficulties in enforcing property rights – Unemployment |
| Country Risk | refers to the risk of investing or lending in a specific country (refers to both political and economic risks) |
| The goal of business strategy: | to create and sustain competitive advantage |
| A firm has a competitive advantage when it is able to create superior value for customers that its competitors are: | – Unable to duplicate – Find too costly to imitate |
| Global Strategy | • Goal: to achieve a low-cost position across all markets • Products are standardized across national markets • Emphasizes economies of scale • Business-level strategic decisions are centralized in the home office |
| Disadvantages of Global Strategy: | – Often lacks responsiveness to local markets – Requires resource sharing and coordination across borders (hard to manage) |
| Multidomestic Strategy | • Goal is to adapt products and services to local preferences • Strategy and operating decisions are decentralized to local business units • Business units in individual countries are independent of each other • Assumes markets differ by country |
| Transnational Strategy | • Seeks to achieve both global efficiency and local responsiveness • Can be thought of as a “hybrid approach” |
| A transnational strategy can be difficult to achieve because of: | conflicting goals: – Close global coordination, which requires central control – Local responsiveness, which requires local autonomy and flexibility |
| Modes of Entry | • Exporting • Licensing • Strategic Alliances • Acquisitions • New Wholly Owned Subsidiary |
| Exporting | • Firm produces products in its home country and ships them to international markets • Avoids the expense and complexity of establishing operations in foreign country • Best when there is a home production advantage |
| Disadvantages of exporting | – Firm does not have total control of marketing and distribution – Can be expensive: shipping costs, tariffs, distribution costs |
| Licensing/Franchising | • Home company grants to a foreign partner firm the right to manufacture and sell products within oneor more foreign markets (Foreign partner firm pays the licensor a royalty) • Foreign firm bears the costs and risks of manufacturing |
| Disadvantages of Licensing/Franchising | – Returns are shared between two parties – Foreign firm can potentially use proprietary technology after licensing agreement expires |
| Strategic Alliances | • Collaboration between two firms – Sharing of risks and resources • Equity-based alliances are known as “joint ventures” – A new legal entity, e.g. a corporation is established – Ownership of the new entity is shared |
| Benefits of Strategic AlBenefits and Risks of Greenfield Venturesliances and Joint Ventures | – Increased revenues – Reduced costs – Enhance learning – Gain exposure to new sources of technology – Reduce (share) risks |
| Risks of Strategic Alliances and Joint Ventures | – Need for clear strategy and support from partners – Need to understand capabilities that partners provide – Trust is essential – Corporate cultural differences can lead to conflict and dysfunctional behavior if not addressed |
| Acquisitions | • Makes the most sense if: – Speed to market is critical – Great need to acquire tangible assets of the target, rather than employees and their expertise – Reasonable to think that integration will be successful |
| Many of challenges associated with domestic acquisitions: | – Costly (acquirer pays a premium) – Integration issues: systems, people, etc. • Can have adverse impact on employee morale – Organizational cultural issues (differences) |
| New Wholly Owned Subsidiary or "Greenfield venture" | a new wholly-owed subsidiary established in another country or market (complex, costly, provides max control) - Most appropriate when parent has all knowledge and resources needed to compete |
| Benefits of Greenfield Ventures | – Can yield higher returns than alliance or j.v. – Provides highest degree of contro |
| Risks of Greenfield Ventures | – Most costly way to enter a foreign market – All risk is assumed by parent – May have limited understanding of a market unless local talent is hired |
| When Expanding Internationally... | • “How will your business benefit?” is not the only question • More important question: “How will your business benefit the foreign country?” • Expect differences • Respect differences • Expect to be at a disadvantage compared to locals |
| “The liability of being a foreigner” | • Refers to the vulnerability of organizations that venture outside of familiar territory • Firms expanding abroad face costs they do not face in their home market |
| “The paradox of being consistent” | Firms with the greatest advantage in their home markets are also the firms most likely to fail when expanding abroad |
| Internal consistency: | consistent, reinforcing value chain activities |
| External consistency: | value chain is designed to take advantage of the home market environment |
| Limited presence in new national market include: | – Export: Significant production advantage in home market – Licensing: Limited ability to fully leverage brand, proprietary business process, patents, or other IP |
| Direct presence in new national market include: | – DIY (“Do it Yourself”) • Greenfield (wholly owned subsidiary; started from scratch) • Acquisition – Cooperative Strategy • Strategic alliance • Joint venture |
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