260 Corporate Finance
Executives report best estimates or expected values; say, for instance, sales of Rs 30 crore. The question is:
What does the executive have in mind when s/he refers to ‘a best estimate of Rs 32 crore’? What probability
does s/he have in mind: 90 percent or 75 percent? The argument can be extended to pessimistic or optimistic
estimates also. Moreover, the executives might have reported what they considered a pessimistic estimate
but the top management may misconstrue it as an expected value. The screen for accepting or rejecting
investment proposals may be coarse or fine depending on the risk aversion of the top management. The
normal practice is to accept those proposals that meet a predetermined financial standard such as 17 percent
ROI or 18 percent IRR, and so on. This policy is not effective since the range of tolerance is not specified. A
better policy would be to specify how top management would prefer to trade off risk and return. An illustration
will clarify the point. Given here are two policies communicated by the top management to the executives:
Policy–1 Policy–2- All projects should be evaluated 1. All projects should be evaluated
on the basis of IRR on the basis of IRR - Accept all projects with IRR > 17 percent 2. Accept those projects that have an expected value of 17
percent or more
a. A probability of 10 percent that IRR will be greater
than 16 percent
b. A probability of 90 percent that IRR will be greater
than 14 percent
Clearly, policy–2 is better as it articulates the risk-taking ability of the top management. Policy–1 gives a
point estimate, which is meaningless in an uncertain world.
Capital Budgeting and Corporate Strategy
The emphasis in most capital budgeting analysis is on estimating and discounting future project cash flows.
Projects with positive NPVs are accepted; those that fail this test are rejected. It should be understood that
generating projects likely to yield positive excess returns is as important as the investment analysis. It is un-
likely that a firm will encounter positive NPV projects by luck all the time; they have to be created. Creating
and taking advantage of product market imperfections is at the heart of corporate strategy. Top down capital
budgeting is not corporate strategy. Competitive Strategy concerns how to create competitive advantage in
each of the businesses a company operates. A good understanding of corporate strategy will help unearth
potentially profitable projects. Shapiro (1985) provides a framework for analyzing the source of positive
NPV projects. Successful investments involve creating, preserving and enhancing competitive advantage that
serve as barriers to entry. There are five major sources of barriers to entry: economies of scale, product dif-
ferentiation, cost disadvantages, access to distribution channels and government policy. Economies of scale
exist whenever a given increase in the scale of production results in less than proportional increase in cost.
The existence of scale economies means that there are advantages in being big. The more significant the
scale economies, the greater the cost disadvantage faced by new entrants to the market. Companies like HLL
take advantage of highly developed marketing skills to differentiate their products, and to keep out potential
competitors by increasing entry costs. Investments aimed at achieving low cost position in the industry coupled
with a pricing policy to expand market share are likely to succeed. Akai, the consumer electronics company,
follows this strategy.