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Introduction
The fundamental success of a strategy depends on three critical factors: a
firms alignment with the external environment, a realistic internal view of its
core competencies and sustainable competitive advantages, and careful
implementation and monitoring.
This paper takes the position that financial goals and metrics help firms
implement strategy and track success. It explains how finance, financial
goals, and financial performance can play a more integral role in the
strategic planning and decision-making process, referred as Strategic
Investment Decision-making. It then highlights the problems with
traditional approach to decision-making and modern approaches developed
for the same.
Background
If we look at any organization today, most of what we see is the outcome of
past strategic investment decisions. The firms assets, tangible or intangible,
can all be traced back to investment decisions made in the past.
More important is the fact that strategic investment decisions often involve a
very substantial outlay of resources, the success or failure of which can have
long term consequences for the firm. Specifically, adopting a given strategic
investment strategy may result in a major departure from the firms previous
operations, significantly affecting its future financial performance and
altering its risk profile as well.
Strategic investments are responsible for turning the firms strategic
positioning into business performance and ultimately into shareholder value.
Indeed, it is through strategic investments that shareholder value is created
2. Economic Value-Added
This is the bottom-line contribution on a risk-adjusted basis and helps
management to make effective, timely decisions to expand businesses that
increase the firms economic value and to implement corrective actions in
those that are destroying its value. It is determined by deducting the
operating capital cost from the net income. Companies set economic valueadded goals to effectively assess their businesses value contributions and
improve the resource allocation process.
3. Asset Management
This calls for the efficient management of current assets (cash, receivables,
inventory) and current liabilities (payables, accruals) turnovers and the
enhanced management of its working capital and cash conversion cycle.
Companies must utilize this practice when their operating performance falls
behind industry benchmarks or benchmarked companies.
4. Financing Decisions and Capital Structure
Here, financing is limited to the optimal capital structure (debt ratio or
leverage), which is the level that minimizes the firms cost of capital. This
optimal capital structure determines the firms reserve borrowing capacity
(short- and long-term) and the risk of potential financial distress. Companies
establish this structure when their cost of capital rises above that of direct
competitors and there is a lack of new investments.
5. Profitability Ratios
This is a measure of the operational efficiency of a firm. Profitability ratios
also indicate inefficient areas that require corrective actions by
management; they measure profit relationships with sales, total assets, and
net worth. Companies must set profitability ratio goals when they need to
operate more effectively and pursue improvements in their value-chain
activities.
6. Growth Indices
Growth indices evaluate sales and market share growth and determine the
acceptable trade-off of growth with respect to reductions in cash flows, profit
margins, and returns on investment. Growth usually drains cash and reserve
borrowing funds, and sometimes, aggressive asset management is required
to ensure sufficient cash and limited borrowing. Companies must set growth
index goals when growth rates have lagged behind the industry norms or
when they have high operating leverage.
8. Tax Optimization
Many functional areas and business units need to manage the level of tax
liability undertaken in conducting business and to understand that mitigating
risk also reduces expected taxes. Moreover, new initiatives, acquisitions, and
product development projects must be weighed against their tax implications
Each member of the Delphi group is asked to list the benefits that would
accrue from the adoption of the proposed investment. Aggregate group
responses - whereby no one individual's response can be detected - are fed
back to all group members.
Research and development method
The research and development (R&D) method views proposed strategic
investments less as capital investment candidates and more as applied
research and development projects, which require further experimentation
and testing before a decision can be made about their practicality and
usefulness. Hence, the name R&D method.
The R&D method is composed of two separate stages. The first stage seeks
to study, simulate, and estimate the proposed investment's benefits. Based
on an evaluation of these benefits, a decision is made to either continue
proceeding with an assess-ment of the proposed investment or stop
altogether.
The second stage of the R&D method seeks to determine if the project's total
costs can be maintained below the level of expected benefits. Such a
determination is often made by implementing the project in a particular
segment or operation of the organization. If the results prove positive, the
next step is to use the acquired cost/benefit data to assess the likely impact
of fully adopting the proposed investment.
There are two distinct advantages gained from using the R&D method. First,
the preliminary working model offers real data on the costs and benefits of
adopting the new investment. Second, the working model provides senior
managers, who might otherwise be skeptical of the projects benefits, with
an opportunity to see and experience what they are buying.
Uncertainty method
The uncertainty method is particularly well suited to situations with highly
uncertain probabilities. While it requires that the individual or group
responsible for the strategic investment decision recognize the likely
monetary outcomes associated with the investment's success or failure, it
does not require an estimate of the probability of success or failure.
There are two main steps to the application of the uncertainty method. In the
first step, the likely monetary effects from the correct and incorrect decision
to adopt the strategic investment and the likely monetary effects from the
correct and incorrect decision not to adopt the investment must be
determined. The inclusion of this latter pair of outcomes ensures that there is
an explicit recognition of the difference between correctly deciding to do
nothing and the mistake of failing to act.
The second step of the uncertainty model involves the selection of a mixture
of optimism-speculation and pessimism-conservatism percentages for the
correct and incorrect outcomes, respectively. These percentages are then
multiplied by the monetary effects that were determined under Step 1. The
decision, either to invest or not invest, is based on which option provides the
highest positive value or the lowest negative value.
Conclusion
Financial performance is one of the key indicators of a firms success and
helps to link strategic goals to performance and provide timely, useful
information to facilitate strategic and operational control decisions. This has
led to the role of finance in the strategic planning process becoming more
relevant than ever.
Empirical studies have shown that a vast majority of corporate strategies fail
during execution. The above financial metrics help firms implement and
monitor their strategies with specific, industry-related, and measurable
financial goals, strengthening the organizations capabilities with hard-toimitate and non-substitutable competencies. They create sustainable
References
Role of finance
http://gbr.pepperdine.edu/2010/08/the-role-of-finance-in-the-strategicplanning-and-decision-making-process/
Managerial judgement
http://www.cimaglobal.com/Documents/Thought_leadership_docs/cid_r
essum_managerial_judgement_and_strategic_investment_decisions_jun
2008.pdf