Last time: Strategy Formulation

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Last time Strategy Formulation
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We looked at

• Game theory

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Strategy Formulation
Game Theory
Maintain
100
70
B
A
60
70
Jones Options
120
80
D
C
20
30
Cut
Maintain
Cut
Smith Options
4
Strategy Formulation
Game Theory
Maintain
100
70
B
A
60
70
Jones Options
120
80
D
C
20
30
Cut
Maintain
Cut
Smith Options
5
Strategy Formulation
Game Theory
Maintain
100
70
B
A
60
70
Jones Options
120
80
D
C
20
30
Cut
Maintain
Cut
Smith Options
6
Strategy Formulation
Game Theory
Maintain
100
70
B
A
60
70
Jones Options
120
80
C
110!
20
30
Cut
Maintain
Cut
Smith Options
7
We looked at

• Game theory
• A. M. Brandenburger B. J. Nalebuff The Right
  Game Use Game Theory to Shape Strategy.
  Harvard Business Review, July-Aug 1995.

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Housekeeping

• Classroom visits still working on that
• Grab me in the hall, lobby, atrium
• John Allison talk terrific response.
• Theme Principled leadership
• Perfect timing for course (implementation)
• Uses BBT as his example, but this is not about
  BBT. Its about integrating who you are and
  what you believe into your strategy and
  operations.
• We still have a few seats. Talk to your
  instructor.
• The WSJ 3 alternative Details in lab.

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The Great Capstone Case Competition
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Presentation Tips (by Mr. Bob Case)

• Gather more information than you can possibly use
  in the allotted presentation time.
• Immersion in business and industry data will make
  your conclusions fact driven.
• The data you dont show likely to be needed to
  answer questions.

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Presentation Tips

• Set the stage with a concise but numbers driven
  summary of the current situation.
• Consider current versus past performance.
• Consider market share and trend.
• Provide summary numerical data on key
  competitors.
• Establish differences (plus and minus) between
  your business and the competition.

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Presentation Tips

• Establish the specific gaps and weaknesses your
  plan is designed to overcome, and the specific
  strengths and differentiations it is intended to
  leverage.
• Create connectivity between the challenges and
  opportunities the current situation holds and
  your proposal.
• Use targeted numerical performance improvements
  to make your case.

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Presentation Tips

• Summarize with data-driven financial specifics of
  how your plan will work.
• Remember Even if youre on the right track, if
  youre not moving youll get run over -
  Will Rogers

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Presentation Tips

• All of your instructors will have additional
  advice regarding content, style, etc.
• But why not also consider this advice from a guy
  who has been there many times (and who will be
  serving as a judge)?
• (Youre not going to have time to do every single
  sub-bullet in Mr. Cases outline)

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Topic Strategic Control
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Strategic Control

• What gets measured, gets done
• What gets measured right, gets done right

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Strategic Control

• KSFs (PLF, sales ft2, occupancy rates)
• Earlier in semester (Exhibit 5.9 examples)
• Financial ratios
• Liquidity
• Activity
• Leverage
• Profitability
• But these dont tell you anything, really!
• (Same way that BP, respiration, pulse, etc. dont
  tell you anything)

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Strategic Control

• KSFs (PLF, sales ft2, occupancy rates)
• Earlier in semester (Exhibit 5.9 examples)
• Financial ratios
• Liquidity
• Activity
• Leverage
• Profitability
• Simple, but useful probes
• Not in isolation, but over time, across the
  industry

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Ratios Liquidity

Current assets ------------------------ Current
liabilities
Current Ratio
Current assets - inventory -----------------------
----------- Current liabilities
Quick Ratio
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Ratios Activity

Sales ---------------- Total assets
Asset turnover
Sales ---------------- Inventory
Inventory turnover
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Ratios Leverage

Total liabilities ------------------- Total assets
Debt ratio
Total liabilities ---------------------------- Tot
al common equity
Debt to equity
EBIT ---------------------- Interest expense
Times interest earned
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Ratios Profitability

Net income ------------------- Total assets
Return on assets
Net income ---------------------------- Total
common equity
Return on equity
Net income ---------------------- Total sales
Return on sales
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Strategic Control

• KSFs (PLF, sales ft2, occupancy rates)
• Earlier in semester (Exhibit 5.9 examples)
• Financial ratios
• Liquidity
• Activity
• Leverage
• Profitability
• Simple, but useful probes
• Not in isolation, but over time, across the
  industry

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Strategic Control

• Alternative measures
• EVA (Economic Value Added)
• Altmans Z
• The Balanced Scorecard (later on)

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Economic Value Added (EVA)

After-Tax Operating Profit - Cost of Capital
Value Created (Destroyed)
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Economic Value Added (EVA)

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Economic Value Added (EVA)

One option is just to look at profits (measure of
your choice) relative to size, measured as
sales, equity, etc.
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Economic Value Added (EVA)

Compare one firm to another how hard is that?
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Economic Value Added (EVA)

But that ignores the true cost of capital!
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Economic Value Added (EVA)
Weighted average cost of capital

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Weighted average cost of capital?

• What debt (bonds)?
• What equity (stock)? (Balance sheet)
• Cost of debt? Easy Interest rate.
• Cost of equity? Not so easy. No mandatory
  payments (dividends)!
• But would you invest in a stock with 0
  anticipated return? Of course not.

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A simple version

• Recall from finance The risk free rate of
  return (things like government guaranteed
  instruments like T-Bills)
• Recall from finance Stocks are riskier
• By how much? (Betas, leverage, etc.)
• Companies know their shadow cost of equity
  The rate of return investors demand in exchange
  for the risk the stock represents

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A simple version

• If risk-free rate is 5, shadow rate of return
  required for stocks will be higher
• Could be 10, 15, 20 or more
• We need to factor that in to our true cost of
  capital. Cant ignore this, just because we
  arent obligated to pay in any given quarter.

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Economic Value Added (EVA)

So if we have, say, 8 billion in invested
capital
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Economic Value Added (EVA)

And the weighted average cost of that is 11.3...
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Economic Value Added (EVA)

Then the total cost of all of that capital is
904 million
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Economic Value Added (EVA)

Where did the 11.3 WACC come from?
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Economic Value Added (EVA)

2/3 of their financing was equity, at 14.3 1/3
was debt, at 5.2. (.6714.3) (.335.2)
11.3
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Economic Value Added (EVA)

So after accounting for the REAL cost of both
debt and equity Spiegel actually destroyed value.
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Economic Value Added (EVA)

Stern Stewart Co. http//www.sternstewart.com/
Specifically, EVA and Strategy http//www.s
ternstewart.com/research/studies2.aspx?ID1291
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Altmans Z

• A way of measuring downside risk, rather than
  positive upside performance
• Assesses the probability of bankruptcy within the
  next 12 months

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Altmans Z

• Z 1.2 X1 1.4 X2 3.3 X3 0.6 X4 1.0 X5
• X1 WC/TA (WC CA CL)
• X2 RE/TA
• X3 EBIT/TA
• X4 MVE/TL (MVE shares /share)
• X5 SALES/TA
• (WC working capital TA total assets CA, CL
  current assets liabilities RE retained
  earnings EBIT earnings before interest
  taxes MVE market value of equity TL total
  liabilities)

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Altmans Z

• Z 1.2 X1 1.4 X2 3.3 X3 0.6 X4 1.0 X5
• X1 WC/TA (WC CA CL)
• X2 RE/TA
• X3 EBIT (yearly)/TA
• X4 MVE/TL (MVE shares /share)
• X5 SALES (yearly)/TA
• Range usually -5 to 10
• -5 to 1.8, immediate danger (85 chance)
• 1.8 to 3.0, gray zone
• 3.0 to 10, no immediate danger

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But what about other settings?
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Privately Held Firms. The X4 term can be
reestimated using book values of equity Z
.717 X1 .847 X2 3.107 X3 .420 X4 .998 X5
(lt 1.23 gt 2.90) Nonmanufacturing Firms.
Eliminate the X5 term b/c of lower asset base of
service/merchandising Z 6.56 X1 3.26 X2
6.72 X3 1.05 X4 (lt 1.1 gt 2.6)
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Control

• You have to know what your quantifiable targets
  are for each goal (objectives)
• You have to know how you will measure them
• You have to have those mechanisms in place before
  you begin
• You have to baseline

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Other stuff

• The Balanced Scorecard will be introduced later
  on