The corporate strategy is your company’s car engine. It drives the business towards its long-terms goals. The marketing strategy is a business-level strategy document, defining how you will attract customers to your product. Irwin Insolvency

You may hear corporate officers, professional investors, and investment analysts discuss a company’s capital structure.

The concept is extremely important because it can influence the return a company earns for its shareholders and whether or not a firm survives in a recession or depression.

Let us now look at what capital structure and corporate strategy is and try to find the link between them.

• What is Capital Structure?
• What Is an Example of Capital Structure? 
• How Do You Calculate Capital Structure?
• Why is Capital Structure Important?
• Factors Determining Capital Structure
• What is Corporate Strategy?
• What Goes Into a Corporate Strategy?
• How to Evaluate Corporate Strategy

What is Capital Structure?

The term capital structure refers to the percentage of capital (money) at work in a business by type. Broadly speaking, there are two forms of capital: equity capital and debt capital.

Read Also: Internal controls: Good or bad for Employees of Accounting Firms?

Each type of capital has its benefits and drawbacks, and a substantial part of wise corporate stewardship and management is attempting to find the perfect capital structure regarding risk/reward payoff for shareholders.

This is true for Fortune 500 companies as well as small business owners trying to determine how much of their start-up money should come from a bank loan without endangering the business.

Let’s take a moment to look at these two forms of capital a bit more closely.

Equity Capital 

Equity capital refers to money put up and owned by the shareholders (owners). Typically, equity capital consists of two types: 

• Contributed capital: The money that was originally invested in the business in exchange for shares of stock or ownership
• Retained earnings: Profits from past years that have been kept by the company and used to strengthen the balance sheet or fund growth, acquisitions, or expansion

Many consider equity capital to be the most expensive type of capital a company can use because its “cost” is the return the firm must earn to attract investment.

A speculative mining company that is looking for silver in a remote region of Africa may require a much higher return on equity to get investors to purchase the stock than a long-established firm such as Procter & Gamble, which sells everything from toothpaste and shampoo to detergent and beauty products.

Debt Capital

The debt capital in a company’s capital structure refers to borrowed money that is at work in the business.

The cost depends on the health of the company’s balance sheet—a triple AAA rated firm can borrow at extremely low rates vs. a speculative company with tons of debt, which may have to pay 15% or more in exchange for debt capital.

There are different varieties of debt capital:

• Long-term bonds: Generally considered the safest type because the company has years, even decades, to come up with the principal while paying interest only in the meantime.
• Short-term commercial paper: Used by giants such as Walmart and General Electric, this amounts to billions of dollars in 24-hour loans from the capital markets to meet day-to-day working capital requirements such as payroll and utility bills.
• Vendor financing: In this instance, a company can sell goods before they have to pay the bill to the vendor. This can drastically increase the return on equity but costs the company nothing. One secret to Sam Walton’s success at Walmart was selling Tide detergent before having to pay the bill to Procter & Gamble, in effect, using P&G’s money to grow his retail enterprise.

• Policyholder “float”: In the case of insurance companies, this is money that doesn’t belong to the firm but that it gets to use and earn an investment on until it has to pay it out for auto accidents or medical bills. The cost of other forms of capital in the capital structure varies greatly on a case-by-case basis and often comes down to the talent and discipline of managers.

Seeking the Optimal Capital Structure

Many middle-class investors believe the goal of life is to be debt-free. When you reach the upper echelons of finance, however, that idea is less straightforward.

Many of the most successful companies in the world base their capital structure on one simple consideration—the cost of capital.

If you can borrow money at 7% for 30 years in a world of 3% inflation and reinvest it in core operations at a 15% return, you would be wise to consider at least 40% to 50% in debt capital in your overall capital structure—particularly if your sales and cost structure are relatively stable.

If you sell an essential product people must have, the debt will be a much lower risk than if you operate a theme park in a tourist town at the height of a booming market.

Again, this is where managerial talent, experience, and wisdom come into play.

The great managers have a knack for consistently lowering their weighted average cost of capital by increasing productivity, seeking out higher-return products, and more.

This is the reason you often see highly profitable consumer staples manufacturers take advantage of long-term debt by issuing corporate bonds.

To truly understand the idea of capital structure, the DuPont model provides insight into how capital structure represents one of the three components in determining the rate of return a company will earn on the money its owners have invested in it.

Whether you own a donut shop or are considering investing in publicly-traded stocks, it’s the knowledge you simply must-have if you want to develop a better understanding of the risks and rewards facing your money.

What Is an Example of Capital Structure? 

Let’s consider two different examples of capital structure: 

Company A, for our purposes, has $150,000 in assets and $50,000 in liabilities. This means Company A’s equity is $100,000. 

The company’s capital structure is therefore such that for every 50 cents of debt, the company makes $1 of equity. 

This, then, would be an example of a low-leverage, or even low-risk, equity capital-structured company. 

Now, take its cross-town rival, Company B. Company B has $120,000 in assets, $100,000 in debt and therefore $20,000 in equity. 

Company B is “highly leveraged.” For every $5 of debt, the company has $1 in equity. This means not only the company needs to increase its returns to be able to finance its debt, eventually, but the company also will be viewed as a greater risk to future lenders.

A real-life example of a vendor financing capital structure was when Sam Walton’s Wal-Mart (now Walmart (WMT) – Get Report ) took off. Walton was able to often sell Tide and other Procter & Gamble products before having to pay P&G (PG) – Get Report , effectively using P&G’s money to grow.

How Do You Calculate Capital Structure?

Since capital structure is the amount of debt or equity or both employed by a firm to fund its operations and finance its assets, capital structure is typically expressed as a debt-to-equity ratio.

To calculate the debt-to-equity ratio, the formula is relatively straight forward.

The company’s total liabilities are divided by its total shareholder’s equity.

Using our previous examples, Company A has $150,000 in assets, and $50,000 in liabilities.

Company A’s equity is determined by subtracting its liabilities from its overall assets, meaning it has $100,000 in equity.

Dividing Company A’s total liabilities of $50,000 by its total shareholders’ equity of $100,000, it has a Debt/Equity ratio of 0.5, meaning for every 50 cents of debt, the company has $1 of equity — and is therefore low-leveraged.

Company B on the other hand, has $120,000 in assets, but $100,000 in debt. That means its equity is $20,000, but its liabilities are $100,000.

Debt/Equity Ratio = $100,000 divided by $20,000 = 5.

This means that for every $5 in debt, Company B hold $1 in equity. That’s why Company B is considered “highly leveraged.”

Why is Capital Structure Important?

1. Increase in value of the firm:

A sound capital structure of a company helps to increase the market price of shares and securities which, in turn, lead to increase in the value of the firm.

2. Utilisation of available funds:

A good capital structure enables a business enterprise to utilise the available funds fully. A properly designed capital structure ensures the determination of the financial requirements of the firm and raise the funds in such proportions from various sources for their best possible utilisation.

A sound capital structure protects the business enterprise from over-capitalisation and under-capitalisation.

3. Maximisation of return:

A sound capital structure enables management to increase the profits of a company in the form of higher return to the equity shareholders i.e., increase in earnings per share.

This can be done by the mechanism of trading on equity i.e., it refers to increase in the proportion of debt capital in the capital structure which is the cheapest source of capital.

If the rate of return on capital employed (i.e., shareholders’ fund + long- term borrowings) exceeds the fixed rate of interest paid to debt-holders, the company is said to be trading on equity.

4. Minimisation of cost of capital:

A sound capital structure of any business enterprise maximises shareholders’ wealth through minimisation of the overall cost of capital. This can also be done by incorporating long-term debt capital in the capital structure as the cost of debt capital is lower than the cost of equity or preference share capital since the interest on debt is tax deductible.

5. Solvency or liquidity position:

A sound capital structure never allows a business enterprise to go for too much raising of debt capital because, at the time of poor earning, the solvency is disturbed for compulsory payment of interest to .the debt-supplier.

6. Flexibility:

A sound capital structure provides a room for expansion or reduction of debt capital so that, according to changing conditions, adjustment of capital can be made.

7. Undisturbed controlling:

A good capital structure does not allow the equity shareholders control on business to be diluted.

8. Minimisation of financial risk:

If debt component increases in the capital structure of a company, the financial risk (i.e., payment of fixed interest charges and repayment of principal amount of debt in time) will also increase.

A sound capital structure protects a business enterprise from such financial risk through a judicious mix of debt and equity in the capital structure.

Factors Determining Capital Structure

The following factors influence the capital structure decisions:

1. Risk of cash insolvency:

Risk of cash insolvency arises due to failure to pay fixed interest liabilities. Generally, the higher proportion of debt in capital structure compels the company to pay higher rate of interest on debt irrespective of the fact that the fund is available or not.

The non-payment of interest charges and principal amount in time call for liquidation of the company.

The sudden withdrawal of debt funds from the company can cause cash insolvency. This risk factor has an important bearing in determining the capital structure of a company and it can be avoided if the project is financed by issues equity share capital.

2. Risk in variation of earnings:

The higher the debt content in the capital structure of a company, the higher will be the risk of variation in the expected earnings available to equity shareholders.

If return on investment on total capital employed (i.e., shareholders’ fund plus long-term debt) exceeds the interest rate, the shareholders get a higher return.

On the other hand, if interest rate exceeds return on investment, the shareholders may not get any return at all.

3. Cost of capital:

Cost of capital means cost of raising the capital from different sources of funds. It is the price paid for using the capital.

A business enterprise should generate enough revenue to meet its cost of capital and finance its future growth. The finance manager should consider the cost of each source of fund while designing the capital structure of a company.

4. Control:

The consideration of retaining control of the business is an important factor in capital structure decisions. If the existing equity shareholders do not like to dilute the control, they may prefer debt capital to equity capital, as former has no voting rights.

5. Trading on equity:

The use of fixed interest bearing securities along with owner’s equity as sources of finance is known as trading on equity. It is an arrangement by which the company aims at increasing the return on equity shares by the use of fixed interest bearing securities (i.e., debenture, preference shares etc.).

If the existing capital structure of the company consists mainly of the equity shares, the return on equity shares can be increased by using borrowed capital.

This is so because the interest paid on debentures is a deductible expenditure for income tax assessment and the after-tax cost of debenture becomes very low.

Any excess earnings over cost of debt will be added up to the equity shareholders. If the rate of return on total capital employed exceeds the rate of interest on debt capital or rate of dividend on preference share capital, the company is said to be trading on equity.

6. Government policies:

Capital structure is influenced by Government policies, rules and regulations of SEBI and lending policies of financial institutions which change the financial pattern of the company totally. Monetary and fiscal policies of the Government will also affect the capital structure decisions.

7. Size of the company:

Availability of funds is greatly influenced by the size of company. A small company finds it difficult to raise debt capital. The terms of debentures and long-term loans are less favourable to such enterprises. Small companies have to depend more on the equity shares and retained earnings.

On the other hand, large companies issue various types of securities despite the fact that they pay less interest because investors consider large companies less risky.

8. Needs of the investors:

While deciding capital structure the financial conditions and psychology of different types of investors will have to be kept in mind.

For example, a poor or middle class investor may only be able to invest in equity or preference shares which are usually of small denominations, only a financially sound investor can afford to invest in debentures of higher denominations.

A cautious investor who wants his capital to grow will prefer equity shares.

9. Flexibility:

The capital structures of a company should be such that it can raise funds as and when required. Flexibility provides room for expansion, both in terms of lower impact on cost and with no significant rise in risk profile.

10. Period of finance:

The period for which finance is needed also influences the capital structure. When funds are needed for long-term (say 10 years), it should be raised by issuing debentures or preference shares. Funds should be raised by the issue of equity shares when it is needed permanently.

11. Nature of business:

It has great influence in the capital structure of the business, companies having stable and certain earnings prefer debentures or preference shares and companies having no assured income depends on internal resources.

12. Legal requirements:

The finance manager should comply with the legal provisions while designing the capital structure of a company.

13. Purpose of financing:

Capital structure of a company is also affected by the purpose of financing. If the funds are required for manufacturing purposes, the company may procure it from the issue of long- term sources.

When the funds are required for non-manufacturing purposes i.e., welfare facilities to workers, like school, hospital etc. the company may procure it from internal sources.

14. Corporate taxation:

When corporate income is subject to taxes, debt financing is favourable. This is so because the dividend payable on equity share capital and preference share capital are not deductible for tax purposes, whereas interest paid on debt is deductible from income and reduces a firm’s tax liabilities. The tax saving on interest charges reduces the cost of debt funds.

Moreover, a company has to pay tax on the amount distributed as dividend to the equity shareholders. Due to this, total earnings available for both debt holders and stockholders is more when debt capital is used in capital structure.

Therefore, if the corporate tax rate is high enough, it is prudent to raise capital by issuing debentures or taking long-term loans from financial institutions.

15. Cash inflows:

The selection of capital structure is also affected by the capacity of the business to generate cash inflows. It analyses solvency position and the ability of the company to meet its charges.

16. Provision for future:

The provision for future requirement of capital is also to be considered while planning the capital structure of a company.

17. EBIT-EPS analysis:

If the level of EBIT is low from HPS point of view, equity is preferable to debt. If the EBIT is high from EPS point of view, debt financing is preferable to equity.

If ROI is less than the interest on debt, debt financing decreases ROE. When the ROI is more than the interest on debt, debt financing increases ROE.

What is Corporate Strategy?

The classic understanding describes corporate strategy as a planned package of measures for the company to achieve its long-term goals. It focuses on how to manage resources, risk and return across the business.

Think of it like a blueprint, with a mid- to long-term perspective, that ensures your business will focus on its core activities and goals over the coming years without taking too many risks along the way.

The corporate strategy is the highest-level document in your business, dealing with the most fundamental aspect of why you are in business.

All the plans, budgets, concepts and projects your teams might draw up to deal with short-term objectives are subordinate to the corporate strategy, because the strategy lays the foundation for how the business will be run.

What Goes Into a Corporate Strategy?

The specifics vary from company to company but, ultimately, the corporate strategy should force you to make the following clear choices:

What products or services should you develop? How should you design your organization? How will you allocate your resources between the various job functions and projects? How will balance the level of risk versus return across the organization?

These four decisions are called the “four pillars” of corporate strategy. Optimizing them means you are on the path to creating a business that is worth more than just the sum of its parts. Let’s look at each pillar in turn.

First Pillar of Corporate Strategy: Portfolio Management

The first pillar of corporate strategy decides w_here the business will “play,”_that is, what products and services it will offer, which markets it will enter and which it will not. Key activity here includes:

• Deciding which products and services to develop and invest in.
• A SWOT analysis (analysis of your Strengths, Weaknesses, Opportunities and Threats) to determine what might be helping or standing in the way of you achieving your goals and objectives.
• Monitoring the growth rate of your products and the actions of competitors to ensure that you’re taking full advantage of any market trends.

Second Pillar of Corporate Strategy: Organizational Design

The second pillar of corporate strategy is making sure the business has right reporting structure, systems and processes in place to turn your ideas into reality. There are all sorts of decisions involved here, such as:

• What business units will you establish?
• How much autonomy will those business units have?
• How will you allocate resources between the various tasks or functions?
• What is an appropriate delegation of authority?
• How will the various teams, departments or functions report to each other?
• How will you monitor performance, to ensure that nothing gets stuck within a department and nothing falls between the cracks? 

Third Pillar of Corporate Strategy: Allocation of Resources

In the context of the corporate strategy document, we’re talking about just two resources: people and money. 

Your business may have other resources such as real estate, machinery or patents, but since these assets are acquired through people or with money, those are the two high-level resources that corporate strategists focus on.

When allocating resources, the main objective is to make sure the whole of your business is greater than the sum of its individual parts. Here are some questions to ask:

• Which people have the most valuable skill sets to your business? Are they in the place they are needed the most? Are you getting the most value out of them?
• Is talent distributed equally across the firm?
• How’s the hiring pipeline? Will you have the right people with the right skills to meet business demand in the future?
• Is your capital invested in assets that are making you money? What financial returns are you getting for every asset you own?

Fourth Pillar of Corporate Strategy: Strategic Trade-offs

Perhaps the most challenging task of corporate strategy is to manage the level of risk the business is taking so it never greater than the returns you’re getting.

Pursuing a truly lateral diversification strategy, for example, is an extremely bold move because you’re expanding into industries the business does not currently operate and has no experience of. This strategy could lead to market leadership or financial ruin, depending on how it all plays out.

In the context of business risks, the corporate strategy should decide how much risk the company is willing to bear as a basis for decision making. Some high-level strategies might include:

• Analyzing high-risk strategies against the expected level of return,  to ensure the business does not cross its own red lines.
• Looking at what has happened before, both to the business and to its competitors, and modifying any proposed strategy based on the required level of risk.
• Ensuring the business does not have all its eggs in one basket so a change in market conditions will not result in disaster.
• Spreading risk over multiple timelines to minimize the impact.

How to Evaluate Corporate Strategy

No good military officer would undertake even a small-scale attack on a limited objective without a clear concept of his strategy. No seasoned politician would undertake a campaign for a major office without an equally clear concept of his strategy.

In the field of business management, however, we frequently find men deploying resources on a large scale without any clear notion of what their strategy is. And yet a company’s strategy is a vital ingredient in determining its future.

A valid strategy will yield growth, profit, or whatever other objectives the managers have established. An inappropriate strategy not only will fail to yield benefits, but also may result in disaster.

Is your strategy right for you? There are six criteria on which to base an answer. These are:

1. Internal consistency.

2. Consistency with the environment.

3. Appropriateness in the light of available resources.

4. Satisfactory degree of risk.

5. Appropriate time horizon.

6. Workability.

If all of these criteria are met, you have a strategy that is right for you. This is as much as can be asked. There is no such thing as a good strategy in any absolute, objective sense. In the remainder of this article I shall discuss the criteria in some detail.

1. Is the Strategy Internally Consistent?

Internal consistency refers to the cumulative impact of individual policies on corporate goals. In a well-worked-out strategy, each policy fits into an integrated pattern.

It should be judged not only in terms of itself, but also in terms of how it relates to other policies which the company has established and to the goals it is pursuing.

In a dynamic company consistency can never be taken for granted. For example:

Many family-owned organizations pursue a pair of policies which soon become inconsistent: rapid expansion and retention of exclusive family control of the firm.

If they are successful in expanding, the need for additional financing soon raises major problems concerning the extent to which exclusive family control can be maintained.

While this pair of policies is especially prevalent among smaller firms, it is by no means limited to them. The Ford Motor Company after World War II and the New York Times today are examples of quite large, family-controlled organizations that have had to reconcile the two conflicting aims.

The criterion of internal consistency is an especially important one for evaluating strategies because it identifies those areas where strategic choices will eventually have to be made.

An inconsistent strategy does not necessarily mean that the company is currently in difficulty. But it does mean that unless management keeps its eye on a particular area of operation, it may well find itself forced to make a choice without enough time either to search for or to prepare attractive alternatives.

2. Is the Strategy Consistent With the Environment?

A firm which has a certain product policy, price policy, or advertising policy is saying that it has chosen to relate itself to its customers—actual and potential—in a certain way.

Similarly, its policies with respect to government contracts, collective bargaining, foreign investment, and so forth are expressions of relationship with other groups and forces.

Hence an important test of strategy is whether the chosen policies are consistent with the environment—whether they really make sense with respect to what is going on outside.

Consistency with the environment has both a static and a dynamic aspect. In a static sense, it implies judging the efficacy of policies with respect to the environment as it exists now. In a dynamic sense, it means judging the efficacy of policies with respect to the environment as it appears to be changing.

One purpose of a viable strategy is to ensure the long-run success of an organization.

Since the environment of a company is constantly changing, ensuring success over the long run means that management must constantly be assessing the degree to which policies previously established are consistent with the environment as it exists now; and whether current policies take into account the environment as it will be in the future.

In one sense, therefore, establishing a strategy is like aiming at a moving target: you have to be concerned not only with present position but also with the speed and direction of movement.

Failure to have a strategy consistent with the environment can be costly to the organization. Ford’s sad experience with the Edsel is by now a textbook example of such failure.

Certainly, had Ford pushed the Falcon at the time when it was pushing the Edsel, and with the same resources, it would have a far stronger position in the world automobile market today.

Illustrations of strategies that have not been consistent with the environment are easy to find by using hindsight. But the reason that such examples are plentiful is not that foresight is difficult to apply. 

It is because even today few companies are seriously engaged in analyzing environmental trends and using this intelligence as a basis for managing their own futures.

3. Is the Strategy Appropriate in View of the Available Resources?

Resources are those things that a company is or has and that help it to achieve its corporate objectives. Included are money, competence, and facilities; but these by no means complete the list.

In companies selling consumer goods, for example, the major resource may be the name of the product. In any case, there are two basic issues which management must decide in relating strategy and resources. These are:

• What are our critical resources?

• Is the proposed strategy appropriate for available resources?

Let us look now at what is meant by a “critical resource” and at how the criterion of resource utilization can be used as a basis for evaluating strategy.

Critical Resources

The essential strategic attribute of resources is that they represent action potential. Taken together, a company’s resources represent its capacity to respond to threats and opportunities that may be perceived in the environment.

In other words, resources are the bundle of chips that the company has to play with in the serious game of business.

From an action-potential point of view, a resource may be critical in two senses: (1) as the factor limiting the achievement of corporate goals; and (2) as that which the company will exploit as the basis for its strategy.

Thus, critical resources are both what the company has most of and what it has least of.

The three resources most frequently identified as critical are money, competence, and physical facilities. Let us look at the strategic significance of each.

Money.

Money is a particularly valuable resource because it provides the greatest flexibility of response to events as they arise. It may be considered the “safest” resource, in that safety may be equated with the freedom to choose from among the widest variety of future alternatives.

Companies that wish to reduce their short-run risk will therefore attempt to accumulate the greatest reservoir of funds they can.

However, it is important to remember that while the accumulation of funds may offer short-run security, it may place the company at a serious competitive disadvantage with respect to other companies which are following a higher-risk course.

The classical illustration of this kind of outcome is the strategy pursued by Montgomery Ward under the late Sewell Avery. As reported in Fortune:

“While Sears confidently bet on a new and expanding America, Avery developed an idée fixe that postwar inflation would end in a crash no less serious than that of 1929.

Following this idea, he opened no new stores but rather piled up cash to the ceiling in preparation for an economic debacle that never came. In these years, Ward’s balance sheet gave a somewhat misleading picture of its prospects.

Net earnings remained respectably high, and were generally higher than those of Sears as a percentage of sales. In 1946, earnings after taxes were $52 million. They rose to $74 million in 1950, and then declined to $35 million in 1954.

Meanwhile, however, sales remained static, and in Avery’s administration profits and liquidity were maintained at the expense of growth.

In 1954, Ward had $327 million in cash and securities, $147 million in receivables, and $216 million in inventory, giving it a total current-asset position of $690 million and net worth of $639 million. It was liquid, all right, but it was also the shell of a once great company.”

Competence.

Organizations survive because they are good at doing those things which are necessary to keep them alive. However, the degree of competence of a given organization is by no means uniform across the broad range of skills necessary to stay in business.

Some companies are particularly good at marketing, others especially good at engineering, still others depend primarily on their financial sophistication. Philip Selznick refers to that which a company is particularly good at as its “distinctive competence.”

In determining a strategy, management must carefully appraise its own skill profile in order to determine where its strengths and weaknesses lie. It must then adopt a strategy which makes the greatest use of its strengths. To illustrate:

The competence of The New York Times lies primarily in giving extensive and insightful coverage of events—the ability to report “all the news that’s fit to print.”

It is neither highly profitable (earning only 1.5% of revenues in 1960—far less than, say, the Wall Street Journal), nor aggressively sold. Its decision to publish a West Coast and an international edition is a gamble that the strength of its “distinctive competence” will make it accepted even outside of New York.

Because of a declining demand for soft coal, many producers of soft coal are diversifying into other fields. All of them, however, are remaining true to some central skill that they have developed over the years. For instance:

• Consolidation Coal is moving from simply the mining of soft coal to the mining and transportation of soft coal. It is planning with Texas Eastern Transmission Corporation to build a $100-million pipeline that would carry a mixture of powdered coal and water from West Virginia to the East Coast.
• North American Coal Company, on the other hand, is moving toward becoming a chemical company. It recently joined with Strategic Materials Corporation to perfect a process for extracting aluminum sulfate from the mine shale that North American produces in its coal-running operations.

James L. Hamilton, president of the Island Creek Coal Co., has summed up the concept of distinctive competence in a colorful way:

“We are a career company dedicated to coal, and we have some very definite ideas about growth and expansion within the industry. We’re not thinking of buying a cotton mill and starting to make shirts.”

Physical facilities.

Physical facilities are the resource whose strategic influence is perhaps most frequently misunderstood.

Managers seem to be divided among those, usually technical men, who are enamored of physical facilities as the tangible symbol of the corporate entity; and those, usually financial men, who view physical facilities as an undesirable but necessary freezing of part of the company’s funds.

The latter group is dominant. In many companies, return on investment has emerged as virtually the sole criterion for deciding whether or not a particular facility should be acquired.

Actually, this is putting the cart before the horse. Physical facilities have significance primarily in relationship to overall corporate strategy. It is, therefore, only in relationship to other aspects of corporate strategy that the acquisition or disposition of physical facilities can be determined.

The total investment required and the projected return on it have a place in this determination—but only as an indication of the financial implications of a particular strategic decision and not as an exclusive criterion for its own sake.

Any appraisal of a company’s physical facilities as a strategic resource must consider the relationship of the company to its environment. Facilities have no intrinsic value for their own sake.

Their value to the company is either in their location relative to markets, to sources of labor, or to materials; or in their efficiency relative to existing or impending competitive installations.

Thus, the essential considerations in any decision regarding physical facilities are a projection of changes likely to occur in the environment and a prediction about what the company’s responses to these are likely to be.

Here are two examples of the necessity for relating an evaluation of facilities to environmental changes:

• Following the end of World War II, all domestic producers of typewriters in the United States invested heavily in plant facilities in this country. They hypothesized a rapid increase of sales throughout the world. This indeed took place, but it was short-lived. The rise of vigorous overseas competitors, especially Olivetti and Olympia, went hand in hand with a booming overseas market. At home, IBM’s electric typewriter took more and more of the domestic market. Squeezed between these two pressures, the rest of the U.S. typewriter industry found itself with a great deal of excess capacity following the Korean conflict. Excess capacity is today still a major problem in this field.
• The steady decline in the number of farms in the United States and the emergence of vigorous overseas competition have forced most domestic full-line manufacturers of farm equipment to sharply curtail total plant area. For example, in less than four years, International Harvester eliminated more than a third of its capacity (as measured in square feet of plant space) for the production of farm machinery.

The close relationship between physical facilities and environmental trends emphasizes one of the most significant attributes of fixed assets—their temporal utility.

Accounting practice recognizes this in its treatment of depreciation allowances. But even when the tax laws permit generous write-offs, they should not be used as the sole basis for setting the time period over which the investment must be justified.

Environmental considerations may reveal that a different time horizon is more relevant for strategy determination. To illustrate again:

As Armstrong Cork Company moved away from natural cork to synthetic materials during the early 1950’s, management considered buying facilities for the production of its raw materials—particularly polyvinyl chloride.

However, before doing so, it surveyed the chemical industry and concluded that producers were overbuilding. It therefore decided not to invest in facilities for the manufacture of this material.

The projections were valid; since 1956 polyvinyl chloride has dropped 50% in price.

A strategic approach to facilities may not only change the time horizon; it may also change the whole basis of asset valuation:

Recently a substantial portion of Loew’s theaters was acquired by the Tisch brothers, owners and operators of a number of successful hotels, including the Americana in Florida. 

As long as the assets of Loew’s theaters were viewed only as places for the projection of films, its theaters, however conservatively valued, seemed to be not much of a bargain.

But to a keen appraiser of hotel properties the theater sites, on rather expensive real estate in downtown city areas, had considerable appeal. Whether this appraisal will be borne out is as yet unknown.

At any rate, the stock, which was originally purchased at $14 (with a book value of $22), was selling at $23 in October 1962.

Achieving the Right Balance

One of the most difficult issues in strategy determination is that of achieving a balance between strategic goals and available resources.

This requires a set of necessarily empirical, but critical, estimates of the total resources required to achieve particular objectives, the rate at which they will have to be committed, and the likelihood that they will be available.

The most common errors are either to fail to make these estimates at all or to be excessively optimistic about them.

One example of the unfortunate results of being wrong on these estimates is the case of Royal McBee and the computer market:

In January 1956 Royal McBee and the General Precision Equipment Corporation formed a jointly owned company—the Royal Precision Corporation—to enter the market for electronic data-processing equipment. This joint operation was a logical pooling of complementary talents.

General Precision had a great deal of experience in developing and producing computers. Its Librascope Division had been selling them to the government for years. However, it lacked a commercial distribution system.

Royal McBee, on the other hand, had a great deal of experience in marketing data-processing equipment, but lacked the technical competence to develop and produce a computer.

The joint venture was eminently successful, and within a short time the Royal Precision LPG-30 was the leader in the small-computer field. However, the very success of the computer venture caused Royal McBee some serious problems.

The success of the Royal Precision subsidiary demanded that the partners put more and more money into it. This was no problem for General Precision, but it became an ever more serious problem for Royal McBee, which found itself in an increasingly critical cash bind.

In March 1962 it sold its interest in Royal Precision to General Precision for $5 million—a price which represented a reported $6.9 million loss on the investment.

Concluding that it simply did not have sufficient resources to stay with the new venture, it decided to return to its traditional strengths: typewriters and simple data-processing systems.

Another place where optimistic estimates of resources frequently cause problems is in small businesses.

Surveys of the causes of small-business failure reveal that a most frequent cause of bankruptcy is inadequate resources to weather either the early period of establishment or unforeseen downturns in business conditions.

It is apparent from the preceding discussion that a critical strategic decision involves deciding: (1) how much of the company’s resources to commit to opportunities currently perceived, and (2) how much to keep uncommitted as a reserve against the appearance of unanticipated demands.

This decision is closely related to two other criteria for the evaluation of strategy: risk and timing. We will now discuss these.

4. Does the Strategy Involve an Acceptable Degree of Risk?

Strategy and resources, taken together, determine the degree of risk which the company is undertaking. This is a critical managerial choice. For example, when the old Underwood Corporation decided to enter the computer field, it was making what might have been an extremely astute strategic choice.

However, the fact that it ran out of money before it could accomplish anything in that field turned its pursuit of opportunity into the prelude to disaster. This is not to say that the strategy was “bad.”

However, the course of action pursued was a high-risk strategy. Had it been successful, the payoff would have been lush. The fact that it was a stupendous failure instead does not mean that it was senseless to take the gamble.

Each company must decide for itself how much risk it wants to live with. In attempting to assess the degree of risk associated with a particular strategy, management may use a variety of techniques.

For example, mathematicians have developed an elegant set of techniques for choosing among a variety of strategies where you are willing to estimate the payoffs and the probabilities associated with them.

However, our concern here is not with these quantitative aspects but with the identification of some qualitative factors which may serve as a rough basis for evaluating the degree of risk inherent in a strategy. These factors are:

1. The amount of resources (on which the strategy is based) whose continued existence or value is not assured.

2. The length of the time periods to which resources are committed.

3. The proportion of resources committed to a single venture.

The greater these quantities, the greater the degree of risk that is involved.

Uncertain Term of Existence

Since a strategy is based on resources, any resource which may disappear before the payoff has been obtained may constitute a danger to the organization. Resources may disappear for various reasons.

For example, they may lose their value. This frequently happens to such resources as physical facilities and product features. Again, they may be accidentally destroyed.

The most vulnerable resource here is competence. The possible crash of the company plane or the blip on the president’s electrocardiogram are what make many organizations essentially speculative ventures.

In fact, one of the critical attributes of highly centralized organizations is that the more centralized they are, the more speculative they are. The disappearance of the top executive, or the disruption of communication with him, may wreak havoc at subordinate levels.

However, for many companies, the possibility that critical resources may lose their value stems not so much from internal developments as from shifts in the environment.

Take specialized production know-how, for example. It has value only because of demand for the product by customers—and customers may change their minds.

This is cause for acute concern among the increasing number of companies whose futures depend so heavily on their ability to participate in defense contracts. A familiar case is the plight of the airframe industry following World War II.

Some of the companies succeeded in making the shift from aircraft to missiles, but this has only resulted in their being faced with the same problem on a larger scale.

Duration of Commitment

Financial analysts often look at the ratio of fixed assets to current assets in order to assess the extent to which resources are committed to long-term programs. This may or may not give a satisfactory answer. How important are the assets? When will they be paid for?

The reasons for the risk increasing as the time for payoff increases is, of course, the inherent uncertainty in any venture. Resources committed over long time spans make the company vulnerable to changes in the environment.

Since the difficulty of predicting such changes increases as the time span increases, long-term projects are basically more risky than are short ones. This is especially true of companies whose environments are unstable.

And today, either because of technological, political, or economic shifts, most companies are decidedly in the category of those that face major upheaval in their corporate environments.

The company building its future around technological equipment, the company selling primarily to the government, the company investing in underdeveloped nations, the company selling to the Common Market, the company with a plant in the South—all these have this prospect in common.

The harsh dilemma of modern management is that the time span of decision is increasing at the same time as the corporate environment is becoming increasingly unstable.

It is this dilemma which places such a premium on the manager’s sensitivity to external trends today. Much has been written about his role as a commander and administrator. But it is no less important that he be a strategist.

Size of the Stakes

The more of its resources a company commits to a particular strategy, the more pronounced the consequences. If the strategy is successful, the payoff will be great—both to managers and investors.

If the strategy fails, the consequences will be dire—both to managers and investors. Thus, a critical decision for the executive group is: What proportion of available resources should be committed to a particular course of action?

This decision may be handled in a variety of ways. For example, faced with a project that requires more of its resources than it is willing to commit, a company either may choose to refrain from undertaking the project or, alternatively, may seek to reduce the total resources required by undertaking a joint venture or by going the route of merger or acquisition in order to broaden the resource base.

The amount of resources management stands ready to commit is of particular significance where there is some likelihood that larger competitors, having greater resources, may choose to enter the company’s field.

Thus, those companies which entered the small-computer field in the past few years are now faced with the penetration into this area of the data-processing giants. (Both IBM and Remington Rand have recently introduced new small computers.)

This does not imply that the “best” strategy is the one with the least risk. High payoffs are frequently associated with high-risk strategies. Moreover, it is a frequent but dangerous assumption to think that inaction, or lack of change, is a low-risk strategy.

Failure to exploit its resources to the fullest may well be the riskiest strategy of all that an organization may pursue, as Montgomery Ward and other companies have amply demonstrated.

5. Does the Strategy Have an Appropriate Time Horizon?

A significant part of every strategy is the time horizon on which it is based. A viable strategy not only reveals what goals are to be accomplished; it says something about when the aims are to be achieved.

Goals, like resources, have time-based utility. A new product developed, a plant put on stream, a degree of market penetration, become significant strategic objectives only if accomplished by a certain time.

Delay may deprive them of all strategic significance. A perfect example of this in the military sphere is the Sinai campaign of 1956.

The strategic objective of the Israelis was not only to conquer the entire Sinai peninsula; it also was to do it in seven days. By contrast, the lethargic movement of the British troops made the operation a futile one for both England and France.

In choosing an appropriate time horizon, we must pay careful attention to the goals being pursued, and to the particular organization involved. Goals must be established far enough in advance to allow the organization to adjust to them.

Organizations, like ships, cannot be “spun on a dime.” Consequently, the larger the organization, the further its strategic time horizon must extend, since its adjustment time is longer.

It is no mere managerial whim that the major contributions to long-range planning have emerged from the larger organizations—especially those large organizations such as Lockheed, North American Aviation, and RCA that traditionally have had to deal with highly unstable environments.

The observation that large corporations plan far ahead while small ones can get away without doing so has frequently been made. However, the significance of planning for the small but growing company has frequently been overlooked.

As a company gets bigger, it must not only change the way it operates; it must also steadily push ahead its time horizon—and this is a difficult thing to do.

The manager who has built a successful enterprise by his skill at “putting out fires” or the wheeler-dealer whose firm has grown by a quick succession of financial coups is seldom able to make the transition to the long look ahead.

In many cases, even if the executive were inclined to take a longer range view of events, the formal reward system seriously militates against doing so. In most companies the system of management rewards is closely related to currently reported profits.

Where this is the case, executives may understandably be so preoccupied with reporting a profit year by year that they fail to spend as much time as they should in managing the company’s long-term future.

But if we seriously accept the thesis that the essence of managerial responsibility is the extended time lapse between decision and result, currently reported profits are hardly a reasonable basis on which to compensate top executives. Such a basis simply serves to shorten the time horizon with which the executive is concerned.

The importance of an extended time horizon derives not only from the fact that an organization changes slowly and needs time to work through basic modifications in its strategy;

it derives also from the fact that there is a considerable advantage in a certain consistency of strategy maintained over long periods of time.

The great danger to companies which do not carefully formulate strategies well in advance is that they are prone to fling themselves toward chaos by drastic changes in policy—and in personnel—at frequent intervals.

A parade of presidents is a clear indication of a board that has not really decided what its strategy should be. It is a common harbinger of serious corporate difficulty as well.

The time horizon is also important because of its impact on the selection of policies. The greater the time horizon, the greater the range in choice of tactics.

If, for instance, the goals desired must be achieved in a relatively short time, steps like acquisition and merger may become virtually mandatory. An interesting illustration is the decision of National Cash Register to enter the market for electronic data-processing equipment. As reported in Forbes:

“Once committed to EDP, NCR wasted no time. To buy talent and experience in 1953 it acquired Computer Research Corp. of Hawthorne, California… For speed’s sake, the manufacture of the 394’s central units was turned over to GE… NCR’s research and development outlays also began curving steeply upwards.”¹¹

6. Is the Strategy Workable?

At first glance, it would seem that the simplest way to evaluate a corporate strategy is the completely pragmatic one of asking: Does it work?

However, further reflection should reveal that if we try to answer that question, we are immediately faced with a quest for criteria. What is the evidence of a strategy “working”?

Quantitative indices of performance are a good start, but they really measure the influence of two critical factors combined: the strategy selected and the skill with which it is being executed.

Faced with the failure to achieve anticipated results, both of these influences must be critically examined. One interesting illustration of this is a recent survey of the Chrysler Corporation after it suffered a period of serious loss:

“In 1959, during one of the frequent reorganizations at Chrysler Corp., aimed at halting the company’s slide, a management consultant concluded: ‘The only thing wrong with Chrysler is people. The corporation needs some good top executives.’

Read Also: What is the Balanced Scorecard and Why is it so Important to Legal Firms?

By contrast, when Olivetti acquired the Underwood Corporation, it was able to reduce the cost of producing typewriters by one-third. And it did it without changing any of the top people in the production group. However, it did introduce a drastically revised set of policies.

If a strategy cannot be evaluated by results alone, there are some other indications that may be used to assess its contribution to corporate progress:

• The degree of consensus which exists among executives concerning corporate goals and policies.
• The extent to which major areas of managerial choice are identified in advance, while there is still time to explore a variety of alternatives.
• The extent to which resource requirements are discovered well before the last minute, necessitating neither crash programs of cost reduction nor the elimination of planned programs. The widespread popularity of the meat-axe approach to cost reduction is a clear indication of the frequent failure of corporate strategic planning.

Conclusion

The modern organization must deploy expensive and complex resources in the pursuit of transitory opportunities.

The time required to develop resources is so extended, and the time-scale of opportunities is so brief and fleeting, that a company which has not carefully delineated and appraised its strategy is adrift in white water.

In short, while a set of goals and major policies that meets the criteria listed above does not guarantee success, it can be of considerable value in giving management both the time and the room to maneuver.