Strategic capital investment

Classification
Type Regulatory Operational Strategic
Definition & OH&S, privacy, Enhance efficiency or Ehance competitive
example. consumer protections, increase revenue: effectiveness: acquire a new
professional and replace/upgrade PPE, business, M&A, expand into
ethical standard, improve internal new market,
industrial relations, processes, increase of introduce/discontinue
sustainability, capacity. products/services

Characteristics These expenditures - These expenditures are They are nondiscretionary.

cannot be deferred or necessary to maintain Usually large and substantial
rejected – they are efficient productive expense.
unavoiable cost of capacity.
doing business
ventilation system, fire - Discretionary, doing
alarm, escape system, nothing is a viable
emergency evacution option.
system.

Who decide? Delegate to unit Delegate to unit Approval of these projects is

managers. managers. reserved for the highest
level of managent.
Analytical tools (1) assets are suitable Managers use three Mostly the current appraisal
to evaluate to the task (2) business analytical techniques to tools may be inadequate on
receives the best value. estimate the benefits: their own
Lowest present value payback, discounted cash
cost option often the flow, internal rate of
norm return.

Why conventional techniques not work for strategic investments?

Uncertain cash flow

 Greater uncertainty associated with cash flow stream.

 Investments reflect a departure from existing operations or technology. It usually involves
innovation or “venturing into the unknown”.
 Benefits later in the cash flow stream may be difficult to estimate with any degree of certainty
and are “penalised” accordingly.
 Strategic investments tend to involve larger outlays and longer payback periods.

Synergy

 Strategic investments often capitalise on synergies (the “whole” integrated package of the firm +
new investment may be worth more than the sum of the parts).
 The synergies tend to be difficult to identify and may be near impossible to quantify.
Qualitative benefits

 Benefits such as higher quality, shorter lead times, broader product range, better environmental
performance are difficult to quantify

DCF wants do not invest

 DCF analysis tends to favour the “do not invest” option and presumes the continuation of the
existing cash-flow stream. This is not false assumption because moving baseline concept
suggests that doing nothing will lead to deteriorating performance.
 Strategic oppportunities may taken up by competitor and the existing cash-flow stream may
decline sharply. In this sense: DCF analysis tends to understate the value of a strategic
investment.

Key strategic issues to consider

Market factors - Alignment with distinctive capabilities and intended strategy
- Strength of competitive advantage arising from the investment
- Impact on reputation
- Corporate Social Responsibility (environmental, social, ethical)
Internal capabilities - Alignment with existing core competencies and capabilities
- Alignment of proposal with existing strategy
- Track record and ability of people involved (champion). A champion, a person
who believes that this asset is an important source of competitive advantage
for the business, willing to argue forcefully for the merits of acquiring it.
- Too optimistic? Does the champion have a good track record of achieving
what they set out to do? Sufficient resources to utilise the asset effectively.
- Impact on the structural cost drivers (scale, scope, complexity, experience and
learning
- Subjectively judge.
Risk of not - Impact of deciding not to acquire the asset (moving-baseline concept)
investing - Another competitor take the opportunity, first movers can create advantages
that are difficult to replicate.

Risk of investing - Ability to manage the risks relating to the investment (strategic, operational,
regulatory, financial)
- opportunity cost? Excess cash return to shareholder? Reaction of
competitors? Different organsation structure?
- Feasibility and cost of reversing decision. Can we reverse it, how much does it
cost?
Quality of - Market analysis, economic forecast, estimation of cash flow, rate of return.
information - right variable? Any contigencies relating to market dynamics? Include brand
supporting value? Economies of scope?
proposal

Moving baseline concept

We can’t just assume the status quo remains the same if we do not invest.
The moving baseline concept challenges conventional comparisons, which are usually between what
might be (financial effect of project) and status quo (things remaining as theay are). The moving baseline
suggests if not adopt the project, status quo is the same, performance deteriorates, competitor gets
first-movers advantage.

Identify suitable components of a strategic capital investment evaluation model

Model Components of model
M1: Treat some items qualitatively, 1. Qualitiative: impact on reputation; core capabilities;
as a screening device, but not part connection to strategy, risk assessment
of quantified model. 2. Quantitative: NPV, IRR, cost-benefit analysis

M2: Quantify all components of the Weighted index. Could use “likert scales” and roll up into a
model. weighted index.
OR use financial analysis (NPV, IRR) and a weighted index of
other factors

Build a weighted index model  evalue the suitability of model (benefits, drawbacks)
 Financial/non-financial factors Calculation Weightings
NPV Ranking all the projects from 40%
highest to lowest NPV. The
highest will receive 10 points.
All negative projects will receive
0 points.
Payback period Ranking all projects from 10%
shortest to longest payback
period. The shortest will receive
10 points.
Alignment with organisational Using Likert scale, 0 if the 20%
strategy project does not align with
organisational strategy and 10 if
perfectly align
Risk and opportunities Using Likert scale, 0 if the 20%
assessment project is highly risky and 10 if
the project is risk-free
Social impact If the project has positive 10%
impact on society, it receives 1
point. If not, it is deducted 1
point.

The new SIM model in which all components are quantified to calculate a weighted index is beneficial
and should be retained to evaluate future strategic capital investment proposal. Firstly, a weighted
index means that it is perfect for comparison between competing proposals for limited fundings. This
model can be applied throughout across different divisions: Wine, Hospitality, Entertainment. Simplicity
is the key benefit of this SIM model at Kilgors. Secondly, using weightings can highlight the varying
degrees of importance of each factor, regardless of financial or non-financial. In Kilgors’ case, there are
seven other qualitative factors, covering key strategic issues such as market factors, internal capabilities,
risk of investing and not investing, which is much more comprehensive than the traditional analytical
tools such as NPV and payback period. In addition, project proposer is forced to investigate across all of
the fifteen factors in the SIM model. This ensures a thorough review and sensitivity analysis on these
proposals, increasing the reliability of information supporting the prosposal.

Market factors
Internal capabilities
Risk of not
investing
Risk of investing
Benefits of the SIM model Drawbacks of the SIM Evaluation Revise
model
a weighted index is highly subjective; Too many performance Create a
perfect for comparison; metrics. benchmark index
as a hurdle
multiple factors weighted some items are hidden, No unique metrics for Separate
 based on importance; only look at the final different plants. qualitative
score assessment

project proposer is forced too simple, the simplicity Does the metrics Create phase I and
to investigate across all of might hide the reflect the strategy phase II.
the factors. complexity of issues map
concerned with the
projects.

Kilgors should implement a benchmark index as a hurdle. In this case,

Build a combined quanlitative and quantitative model

Explain how strategic investment evaluation model (SIEM) works.

If the current model (NPV) is used, the proposal is rejected because of negative NPV. However, the new
model is much more comprehensive. A weighted index is perfect for comparison. This weighted index is
a quantitative model and is applicable across the organisation, capable of capturing the specifics of
different kinds of capital investments. Multiple financial and non-financial factors are given weigthings
based on importance. NPV continues to play a major role. However, project proposer is forced to
investigate all other non-financial factors.

Alignmnet with the organisational strategy.

It is in the best interests of the shareholders if the project is in-line with the organisational strategy. The
orange juice project is diversifying the product portfolio because its current carbonated drink market is
shrinking. In addition, the orange juice project develops positive reputation with fruit suppliers, paving
the way for many similar investments in the long-term.

Risks and opportunties assesmsent.

Risk and opportunies relating to the investment such as strategic, operational, regulatory, financial are
reviewed. For example, Bulle faces the strategic risk of highly competition and significant barriers to
entry. However, there are operational opportunies such as an amply supply of oranges in Queensland
and a chamption who in the past year have performed better than expected. There is not much
regulatory risks because orange juice is often seen as healthy drinks unless the sugar level is alarmingly
high. Financial risk is that this is a negative NPV project.

Social impact.

Positive social impacts of orange juice such as reducing unemployment rate by creating extra 500 jobs
and producing healthier drinks should be recognised.

Comment on Kilgors’ strategic investment case

Benefits of using SIM model:

Our model is fullly quantitative model. Using a weighted index is perfect for comparison between
competing proposals. Also, multiple factors are weighted based on importance. Project proposer is
forced to investigate across all of the factors. Three most critical non-financial factors that drive your
evaluation of the project you ranked number one. Alignment with intended strategy. Alignment with
core competencies and capabilities. Risk factor. This is a thoughtful consideration of strategic issues.

Drawbacks of using SIM model:

Judgement are highly subjective.

Each person on pannel did their own evaluation. Better to disagree than everyone agrees.

If you alter the weighting of factors, the outcome will be different.

Some items will be hidden because we tend to look at the final score.
Simplicity hides some of the complexity requried when making decision. Even the NPV is subjective.

Are the financials “credible enough”? The number must undergo sensitivity analysis, discussion with
accounting department, a robust analysis. Challenge the numbers.

Jack is dropped off because his project is operational. Is it really if it has technology aspect? And not just
pure maintenance.

First impression could impact the evaluation. Presentation style.

Reward system

Replace some BSC metrics: think of 4 common mistakes in BSC, not link to strategy; not validate the link;
not right target; not measure correctly

Metrics Link to strategy Validity Reliability

A number of team- There seems to be no It does captures It is quantifiable and
implemented direct link to strategic promotion knowledge can be measured free
solutions lever. However, it does sharing across the of measurement error.
relates to “human organisation
capital”
Number of There seems to be no It does captures It is quantifiable and
additions to Ass direct link to strategic promotion knowledge can be measured free
internal database lever. However, it does sharing across the of measurement error.
p.a. relates to “information organisation
capital”
Voluntary staff It links to “recruit and However, it fails to It is quantifiable and
turnover develop our people” capture what we want, can be measured free
the “openness and of measurement error.
collaborative culture”
because there are
various reasons why
staff decided to quit
Diversity of It does link to strategic However, it fails to It is quantifiable and
qualifications of plank: “recruit and capture what we want, can be measured free
our staff and develop our people to which is to promote of measurement error.
employee be high-performing excellence in all that
professionals”. we do. It relates more
to “maintain an open
and collaborative
culture”
Number of industry It links to strategic It does captures It is quantifiable and
awards won lever “delivery of first- excellence in all that can be measured free
rate client solutions” we do of measurement error.
 Which measure is The new measure How it will be Why it should be part
being replaced calculated of BSC for Wine div.
Reduction in Asset turnover Sales revenue/ Net profit margin and
production costs Employed assets reduction in production
costs may tell the same
story. Asset turnover
implies how well the
management utilises its
resources.
Customer retention Market share Net revenue generated Customer retention
by Wine division and customer
compared to top 10 satisfaction rating
wine companies might tell the same
story. Also, SW division
strategy is to lead the
market. Market share
metrics will be more
informative about SW’s
ability to expand
customer base and
increase sales volume.
Employee productivity Sustainability: water based on 9 litre We need to consider
(output per employee efficiency equivalent per case the environmental
hour; kg/hr) impacts.
Long-term incident free Training employees Number of hours The incident rate is a
rate attended by empoyees metrics that we are
interested in. However,
it should not be in the
balanced scorecard
because it doesn’t link
to the strategic
objectives. Employee
engagement index and
employee satisfaction
survey are conflicting
at all three plants.

If there is a causal relationship between the two metrics, these two metrics can be used in balanced
scorecard because the link is validated.

Mistakes Describe mistakes Solutions

 Not linking measures to Treat BSC as off-the-shelf Choose metrics based on causal
strategy checklist or procedure that is models, value driver maps, lay out the
universally applicable and plausible cause-and-effect
completely comprehensive relationships that may exist between
the chosen drivers of strategic success
and outcome

Not validating the links Does accelerating product- Based weightings purely on their
Not investigate whether development time lead to assumptions about measures’
there is a plausible increase market share (not if our strategic importance
relationship between new products are only minutely
actions and outcomes, different from our earlier models
or we have merely reverse-
engineered those of our
competitors).
Not setting the right Outstanding nonfinancial Need to understand when the pay-off
performance targets performance is not always comes for an improvement in a non-
beneficial. It often produces financial performance measure ….
diminishing or negative eocnomic Sometimes seeking further
returns. 100% customer improvement in a measure is counter-
satisfaction. productive.

Measuring incorrectly Validity (a metric suceeds in Non-financial measures are

subjective in nature, capturing what is supposed to inconsistent across thec ompany.
“soft”, measures must be capture); Reliability (free of Different business units within same
quantifiable measurement error) company used different
methodologies to measure the same
things, resulting in conflicting results.

List all key challenges of using BSC as basis of bonus system:

Finding a suitable allocation formula to distribute the bonus between divisions/work-units/managers.

Do we include all measures; all perspectives’ and if so, how it would be weighted?

Percentage method.

The score is the percentage by which the target is exceeded. If the target is not exceeded, then the
score is zero. The agreegate score is the weighted sum of all the scores. Weights are allocated by senior
managers. The bonus pool may be allocated pro-rata relative to the aggregate score.

Multiply method.

The score for each metric is calculated by dividing the value attained by the specified target, and raising
the ratio to a specified power. If the result exceeds the target, then the score is greater than 1,
otherwise the score is less than 1. The aggregate score is the product of all metric scores. The power
(alpha) is specified by the senior manager. The bonus pool may be allocated pro-rata relative to the
aggregate score.

Short-comings of the allocation system Improve allocation systems

 1 if reached, 0 if not reach.  Specific metrics. (Managers often focus

on common measures and forget unique
 Equal weighting to all metrics.
measures to each of the plant’s
 No incentives to do anything or disregard circumstances)
environmental impact.
 Drop some metrics (Difficult to sustain a
 No reward for exceeding the targets. Just complex compensation scheme with too
meet the target is enough many metrics)

 No penalties for missing long away from  Reward for exceeding the targets.
the target. The effect on the bonus is the Penalise for missing the target
same.
 Build in hurdles: must meet 50% of target

It rewards for exceeding the targets and penalises for missing the target. It also has a built-in function to
consider how far below or above the target each division is perfoming at. Also, it has specific metrics so
that managers will not focus solely on common measures and forget the unique measures to each of the
division.

Problems with current “performance pay incentive” bonus plan

Traditional financial metrics tend to be unhelpful at the operational level because they tend to be
lagging indicators and results-oriented. The don’t identify causes of business performance. They tend
to be ineffective as a warning signal for emerging problems. The information they provide may not help
managers decide on the most effective corrective action; Since they only capture aggregated business
performance – profit, revenue, ROI, RI, EVATM, debt and equity levels, etc

The use of traditional financial metrics in an organisational control is limited due to short-term
orientation and restuls-orientation. Easy to game the system. Short-term focus: cut R&D to produce
higher earnings today. Accelerate revenue recognition or postpone discretionary expenditures.

Benefits of BSC as basis of bonus system

It is

Use multiple metrics. It is very hard to game multiple interconnected targets simultaneously. Include
non-financial targets. Metrics such as brand, reputation, sustainability rankings are set by outside
agencies and so are hard for managers to manipulate.
Non-financial metrics capture performance at the operational level – customer satisfaction, quality
control, productivity, capacity utilisation, efficiency, employee engagement, innovation, market share,
competency, etc. They tend to be leading indicators, process-oriented and enablers in an organisation.
They identify causes of business performance and inform decisions relating to corrective action.

Validity: Capture what is intended. Inappropriate measures can be chosen. It might not reflect the
objective at all. Different business units withint the same company used different methodologies to
measure the same things. For example, to calculate employee turnover, one uses total employee
turnover regardless of reasons, the other uses voluntary employee turnover. This leads to conflicting
results.

Reliability: Free of measurement error. Non-financial measures are “soft” and subjective in nature. Non-
financial measures must be quantifiable.

It is a good idea to use the scorecard as the basis of a bonus system. Firstly, using multiple metrics as a
basis for bonus plan makes it very hard to game the system because manipulating multiple
interconnected targets such as “sales revenue” and “profit magin” and “residual income” are much
harder than simply a bonus based on sales revenue. Secondly, this scorecard do take into account the
unique features of each division. It is evident in the metrics used in internal business process. Publishing
division is assessed on number of new titles published; Retail divison is assessed on sales per equivalent
full-time employee; Technology is assed on percentage of projects on time on budget. The combination
between common and unique/specific metrics implies that the bonus will be allocated fairly across three
divisions. In addition, these metrics are all quantifiable, reducing the subjective judgment in bonus
allocation.

Develop a bonus plan

Who incentives apply to Senior executives, divisional managers, unit

managers, other
Performance is measured at Share price and economic added value is better
individual/divisional/corporate levels to applied at corporate level.
Short-term, long-term
Relative performance Rank and yank at GE

To suggest a bonus system, it is assumed that incentives are applied to divisional managers at
Publishing, Retail and Technology divisions; the performance is measured at divisional level.

Strategy map

What makes a successful strategy map?

Strategy maps provide a set of causal relations between strategic objectives and informs the
development of BSC metrics. It provides a visual presentation of connection between critical objectives
and drivers of organisational performance. For example, how “encouraging and promoting knowledge
sharing across the organisation” will speed up time delivery of project and quality of client solution.

Strategy maps should facilitate and improve manager’s decision making. It shows how implementing a
business strategy will enable an organisation convert its resources into meaningful outcomes. It acts as
communciation tool, giving employees a clear insight into how their jobs are linked to the overall
objectives of the organisation, enabling them to work in a coordinated, collaborative fashion toward the
company’s desired goals.

What makes a succesful BSC

 Should be crafted from organisation’s strategy map.

 Applied throughout company. More user-friendly and relevant to non-management employees
 Long-term horizon. More likely to lead to longer term performance gains, as they tend to be
linked more readily to the organisation’s goals. Tend to dimish the likelihood of myopic
management decision, as they usuallly promote more long-term thinking
 Link to strategy. Can be easily structured to suit an organisation’s goals
 Lead vs lag indicators. Can identify problem in a more timely fashion and locate the entity’s
problems and benefits

Two key factors influencing suitability of non-financial measures in a BSC

= When selecting non-financial measures the following questions should be asked:

Validity: Capture what is intended. Inappropriate measures can be chosen. It might not reflect the
objective at all. Different business units withint the same company used different methodologies to
measure the same things. For example, to calculate employee turnover, one uses total employee
turnover regardless of reasons, the other uses voluntary employee turnover. This leads to conflicting
results.

Reliability: Free of measurement error. Non-financial measures are “soft” and subjective in nature. Non-
financial measures must be quantifiable.

Costs of BSC

 How is the required data collected?

 What if we collect and use proxy data for the measure?
 What’s the cost of collecting data, generating reports and circulating the reports?
 Are their compliance issues such as privacy laws, commerical, confidentiality.

Construct a strategy map & balanced scorecard

Internal transfer pricing

Eccles’ five organisational characteristics that influence internal transfer pricing policy.

- The nature of corporate strategy and the strategic planning process

- The primary means of control by top management
- The criteria for performance measurement, evaluation, and reward
- The definition of fairness in the company
- The nature of the managerial processes

Characteristic Competitive Cooperative Collaborative

Nature of corporate Aggregate of division’s Total company strategy Mutually defined total
strategy, strategic strategies company business
planning process perspectitves
Structure Multidivisional Functional Matrix
Systems criteria for Profits, ROI compared with Costs compared with budgets Combination of costs, profit,
performance budget, internally and and history and ROI compared with
measurement, externally budget
evaluation, reward
Managerial Bottom-up; distributive Top-down; integrative Iterative; mixed-mode
processes bargaining bargaining bargaining
Method of Impartial spectator Shared fate Rational trust
managers’ fairness
evaluation Definition
of fairness in the
company
Top management Through systems on outcomes Through structure on actions Through processes balancing
control structure and systems
Transfer pricing Dual pricing, market price, use full cost. The purpose of market price less discount
method constraint sourcing, Use market transfer prices is to accumulate (no selling costs, credit risk)
price less discount (no selling total costs as if the end or cost-plus-profit markup if
costs, credit risk) or cost-plus- products were manufactured no market price
profit markup if no market price completely within a signle
business unit.

Which method to use?

- Eccles: five factors: organisation strategy, structure

- Availability of market price
- Idle capacity = variable cost, no idle capacity = market price

Problems:

- Frequency: recurrent or one-off

- Magnitude: overall business volume
- Level of sourcing autonomy

Method Definition Used when Isssues

Cost based Costs of Marketprice is not available: - Reduce incentives to manage costs
producing the unique product customised for effectively because costs are passed on
products. internal supply; managers’
- Unfair distribution of profits between
Variable cost, sourcing autonomy is limited
division: buying div get all the benefits
full cost, cost
 plus mark-up while selling div only recover costs

Market- External Perfectly competitive market Information about underlying costs is

based market price not revealed
Negotiated Autonomy is encouraged, Require more time for negotiation
transfer managers negotiate among
price themselves and agree on a
satisfactory price. Market
price unavailble or production
costs are unstable.

Dual Use 2 separate transfer-pricing Overstate profitability at sub-unit level.

transfer methods. Difference between the two transfer
pricing prices is recorded in corporate cost
account and borne by the company

Intervene Overlook/Not intervene

 Would result in serving low-cost bid interests of Birch  Results in increased costs to Birch (relatively
 Profits can be shared evenly between the divisions (considerig small given transactions is <5% of total volume
bargaining power) Share profits evenly between Thompson and in question)
Southern. Force Thompson’s SP at $430 (market). Use of dual  No (little) profits are generated for Thompson or
price? Need to be careful here Southern
 Undermines the decentralisation policy  Leaves conflict to divisional managers and
 Compromises the sourcing autonomy of divisional managers perhaps unresolved.
 A new policy may be required to avoid ongoing disputes  Preserves the decentralisation policy
 Strengthens relationship with suppliers
 No impact on quality … assuming there is
no material differences between inputs.

Outline why transfer pricing matters in organisation

- Performance evaluation: managers should not be held responsible for costs over which they
have no control
- Facilitation of decision-making: suboptimal decision making but not for the whole organisation
- Goal congruence: conflicts among managers

Final exam answer space