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Questions and Answers
What is value created defined as?
What is value created defined as?
Which approach focuses on maximizing the wealth of owners?
Which approach focuses on maximizing the wealth of owners?
What is a major rationale for firms to maximize profits?
What is a major rationale for firms to maximize profits?
What does it mean for a firm's return on capital to be greater than its cost of capital?
What does it mean for a firm's return on capital to be greater than its cost of capital?
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Why are firms that do not maximize profits vulnerable to acquisition?
Why are firms that do not maximize profits vulnerable to acquisition?
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Which of these is NOT an aspect of the stakeholder approach?
Which of these is NOT an aspect of the stakeholder approach?
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What is implied by the term 'rents' to input providers?
What is implied by the term 'rents' to input providers?
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What factor is crucial for firms to achieve long-term profitability?
What factor is crucial for firms to achieve long-term profitability?
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What is the return on assets (ROA) percentage for UPS?
What is the return on assets (ROA) percentage for UPS?
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Which company has a higher maintenance cost as a percentage of sales?
Which company has a higher maintenance cost as a percentage of sales?
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How does UPS's fuel cost percentage compare to FedEx's?
How does UPS's fuel cost percentage compare to FedEx's?
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What is the PPE turnover ratio for FedEx?
What is the PPE turnover ratio for FedEx?
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Which of the following indicates that UPS is more efficient than FedEx in managing its cash?
Which of the following indicates that UPS is more efficient than FedEx in managing its cash?
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What is a primary challenge when estimating cash flows?
What is a primary challenge when estimating cash flows?
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What is a strategy for maximizing value on existing assets?
What is a strategy for maximizing value on existing assets?
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What should a new investment's rate of return exceed to ensure its viability?
What should a new investment's rate of return exceed to ensure its viability?
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What does the Return on Equity (ROE) measure?
What does the Return on Equity (ROE) measure?
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Which of the following formulas is correct for calculating Return on Capital Employed (ROCE)?
Which of the following formulas is correct for calculating Return on Capital Employed (ROCE)?
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What does Gross Margin measure?
What does Gross Margin measure?
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Why might value maximization promote short-termism?
Why might value maximization promote short-termism?
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Which profitability ratio measures the return generated on total assets?
Which profitability ratio measures the return generated on total assets?
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Which of the following factors is directly linked to performance targets for order size?
Which of the following factors is directly linked to performance targets for order size?
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What performance target is associated with assessing the effectiveness of inventory management?
What performance target is associated with assessing the effectiveness of inventory management?
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Which value driver relates to the assessment of costs in relation to sales?
Which value driver relates to the assessment of costs in relation to sales?
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Which of these metrics would best indicate the capital utilization of a company?
Which of these metrics would best indicate the capital utilization of a company?
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Which of the following factors is NOT a performance target linked to shareholder value creation?
Which of the following factors is NOT a performance target linked to shareholder value creation?
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What is the formula to calculate operating margin?
What is the formula to calculate operating margin?
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Which profitability ratio measures the firm's success in using shareholders' capital to generate profits?
Which profitability ratio measures the firm's success in using shareholders' capital to generate profits?
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What does enterprise value represent?
What does enterprise value represent?
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Why is enterprise value preferred over shareholder value maximization?
Why is enterprise value preferred over shareholder value maximization?
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What is the formula for Return on Capital Employed (ROCE)?
What is the formula for Return on Capital Employed (ROCE)?
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How does net margin differ from operating margin?
How does net margin differ from operating margin?
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Which profitability ratio should be used to assess the return on all company assets?
Which profitability ratio should be used to assess the return on all company assets?
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What is a significant concern with shareholder value maximization?
What is a significant concern with shareholder value maximization?
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What does EBITDA stand for?
What does EBITDA stand for?
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How is gross margin calculated?
How is gross margin calculated?
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Which of the following measures a firm's ability to extract profit from its sales?
Which of the following measures a firm's ability to extract profit from its sales?
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What is one component used in disaggregating ROA?
What is one component used in disaggregating ROA?
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Which ratio indicates how effectively a company uses its assets to generate sales?
Which ratio indicates how effectively a company uses its assets to generate sales?
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Which term describes the relationship between Sales and Receivables?
Which term describes the relationship between Sales and Receivables?
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The operating margin is influenced by which of the following?
The operating margin is influenced by which of the following?
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Study Notes
Contemporary Strategy Analysis - Chapter 2
- Strategy as a quest for value: Business exists to create value, often driven by the founder's vision (e.g., Henry Ford, Steve Jobs, Jack Ma). Value is the monetary worth of a product, and firms aim to create value for customers and appropriate part of that value as profit for survival.
What is Business For?
- Every business has a unique purpose, often reflecting the founder's motivations.
- Examples include Henry Ford (Ford Motor Company), Steve Jobs (Apple), and Jack Ma (Alibaba).
- All businesses have a fundamental desire/need to create value.
Value Creation
- Profit = Revenue - Cost
- Value created = Consumer surplus + Producer surplus
- Profit is what customers pay, and the difference between input costs and what customers paid.
- Consumer surplus and producer surplus make up a product's value.
Value for Whom? Shareholders vs Stakeholders
- Shareholder approach: The firm exists to maximize the wealth of its owners.
- Stakeholder approach: The firm is a coalition of interest groups. It must create value for all of them; customers, motivated employees, and good relations with governments and communities.
- To simplify strategy analysis, the primary goal of a firm is assumed to be maximizing profit over its lifetime.
- Competition requires a firm to earn a return on capital greater than the cost of capital.
- Firm performance is vulnerable to acquisition if not maximizing profits.
- Healthy profitability drives customer satisfaction and good relations with employees and stakeholders.
Profit, Cash Flow, and Enterprise Value
- Profit: Different measures (e.g., Return on Sales [ROS], Return on Equity [ROE], Return on Assets [ROA], Return to shareholders) show different company rankings.
- Linking profit to enterprise value: Profit maximization is ambiguous (measuring total profit vs. rate of profit, time period). Maximizing enterprise value is clearer, focusing on net present value of free cash flows.
- Enterprise value (V): Net present value of free cash flows equals the sum of the present value of all future free cash flows.
Value Maximization and Strategy Choice
- Use Discounted Cash Flow (DCF) approach to choose strategies.
- Estimate cash flows and costs of capital for each strategy.
- Select the strategy that maximizes Net Present Value (NPV).
- Estimating cash flows is difficult more than 2-3 years out, leading to potential short-termism.
Profitability Ratios
- Return on Capital Employed (ROCE): Measures return on the capital invested in a business.
- Return on Equity (ROE): Measures the firm's success using shareholders' capital to generate profits available to investors.
- Return on Assets (ROA): Measures the firm's use of all assets.
- Other profitability ratios include Gross margin, Operating margin, and Net margin.
Enterprise Value and Shareholder Value
- Enterprise value = Market capitalization of equity + Market value of debt.
- Maximizing enterprise value may be preferable to maximizing shareholder value as distinctions between debt and equity are not always clear.
Putting Performance Analysis into Practice
- Profitability ratios: used for performance analysis, including ROCE, ROE, ROA, gross margin, operating margin, and net margin.
- Disaggregating ROA: Breaking down ROA into components to better understand performance drivers—Sales margin, turnover ratios (Fixed asset, inventory, creditor, sales).
- The key to analyzing profitability is to disaggregate the ROA in order to improve the firm's performance.
Linking Value Drivers to Performance Targets
- Key drivers linked to ROCE (return on capital employed) include sales/cogs, development costs/sales, inventory turnover, and capacity utilization.
- Metrics (e.g., order size, customer mix, customer churn) help to assess customer satisfaction and performance.
- Financial Performance, customer satisfaction, employee satisfaction, and corporate social responsibility.
Balanced Scorecard for a Regional Airline
- Financial perspective: Increase profitability, increase seat revenue, minimize costs.
- Customer perspective: On-time arrival, customer satisfaction, high customer quality.
- Internal perspective: Improve on-time departure, and decrease ground time.
- Learning perspective: Employee training, and alignment of the ground crew.
Pitfalls of Pursuing Shareholder Value: Boeing
- Boeing's pursuit of shareholder value (focused on building planes) led to financial problems in later periods.
Beyond Profit: Values and Corporate Social Responsibility
- Values and principles commit organizations to ethical precepts and guidelines for behavior.
- Deeply held values are conducive to motivating employees, reinforcing strategic direction, and enhancing organizational unity.
- CSR (Corporate Social Responsibility) isn't just a goal; it can create long-term profit by enhancing adaptability, reputation, and legitimacy.
Beyond Profit: Strategy as Options Management
- Real options are investments that create opportunities for firms in turbulent environments.
- Examples are growth options (e.g. research) and flexibility options.
- Real options are valued using Black-Scholes or binomial pricing models to simulate future circumstances.
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