Chapter

Three
Competencies
and
Profitability-
Analyzing
Internal
Resources
 McDonald’s Competitive Advantages
 Started in 1955 it has grown into the biggest restaurant chain. Success formula:
• Give consumer value for money
• Good quick service
• Consistent quality in good environment
• High employee productivity due to standardized process
• Close ties with wholesalers and food producers, and managing supply chain to
reduce cost
• As it become larger its buying power enabled it to realize economies of scale,
and pass on cost savings to customers in the low priced meals
 It worked fine in 1990s and early 2000s. Then it was under attack of health
consciousness. By 2002 sales were stagnating, and profits were falling. So there
was a corporate makeover like:
• Top management changed
• Unlike before it introduced healthier food like salad and apple slice etc.
• Did research to observe that consumer preference changes from beef to
chicken and acted accordingly
• Another emphasis was on beverages, in line with the success of Starbucks.
Fast and good coffee was a focus. Price control was never undermined..
• The next change is in design. The aging design being replaced by wide screen
TV and Wi-Fi connection.
 The change was successful: From 2002 to 2008 net profit increased from $1.7
billion to $4 billion, Sales revenue increased from $15.4 billion to $24 billion.
Copyright © Houghton Mifflin Company. All rights 3|2
 Competitive Strategy Analysis

 This is the strategy of positioning a firm in the

industry. It refers to the strategy of the competitive
advantage of the firm over other firms of the same
industry. Commonly it is either (i) Cost Leadership or
(ii) Product Differentiation.
 (i) Cost Leadership refers to the firm’s advantage in
the cost of production. This depends on the
production system.
 (ii) Product Differentiation refers to the advantage of
the firm regarding the specification of the product.
This depends on the acceptability of customers on the
marketing point.
 Competitive Strategy
1. Cost leadership
• Attaining, then using the lowest total cost basis as a competitive
advantage. Cost Leadership means to create sustainable cost
advantage over rivals with regard to same product or service. It
arises from:
» Economies of scale: To explore the optimum scale
» Economies of learning: Complication of technology of
production. Both short run and long run
» Efficient production: constrained optimization
» Simpler product design: Alter value chain to bypass cost-
producing activities.
» Lower input cost: procure or produce?
» Low cost distribution: owning or hiring?
» Little research and development or brand advertisement.
Industry standard? Cost-benefit of low R&D?
» Tight Cost Control system: To ascertain the cost centre,
standardize costs and identify the agent responsible for
variation

Copyright © 2001 Houghton Mifflin Company. All rights reserved. 1-4

 Cost Leadership in case of identical
commodity

Industry Firm

Si Sf 1
Price

Price
(MC)
Sf 2
AC1
Tk.50 D=AR=
AC2
MR

D
(MU)

Qi Qf 1 Qf 2
Quantity in million Quantity in thousands

Copyright © 2001 Houghton Mifflin Company. All rights reserved. 1-5

 Competitive Strategy
2. Product Differentiation

Product differentiation strategy seeks to be unique

in industry along some lines highly valued by
customers. It implies to identify such attributes, and
meet that in a unique and cost-efficient way. It
involves:
• Superior product quality
• Superior product variety
• Superior customer service
• More flexible delivery
• Investment in brand image
• Investment in R&D, engineering skills and marketing
capabilities
• More focus on creativity and innovation.
Concentrating competitively on a specific market segment
Business-Level Strategies: 3. Market niche focus
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 Advantage of product differentiation

Without differentiation: With differentiation:

Elastic demand curve Relatively Inelastic demand curve

MC MC

AC AC
AR=MR
Price

D=AR

MR

Quantity Quantity

Copyright © 2001 Houghton Mifflin Company. All rights reserved. 1-7

 Internal Analysis
The purpose of internal analysis is to pinpoint the strengths and
weaknesses of the organization.
Strengths lead to superior performance. Weaknesses lead to
inferior performance.

Internal Analysis includes an assessment of:

 Quantity and quality of a company’s resources and
capabilities
 Ways of building unique skills and company-specific or
distinctive competencies

Internal analysis - along with the external analysis of the company’s

environment - gives managers the information to choose the
strategies and business model to attain a sustained competitive
advantage.
 The Roots of Competitive Advantage
 Distinctive Competencies
• A firm’s profitability is greater than the average profitability for all firms in its industry due to cost
leadership or product differentiation.
 Resources
• Company specific advantages of tangible (like equipment) and intangible (like belongingness)
 Capabilities
• Capabilities refer to a company’s skills at coordinating its resources and putting them in productive
use. It refers to internal rules, routines and procedures to achieve the goals; like demand creation,
 Sustained Competitive Advantage
• A firm maintains above average and superior profitability and profit growth for a number of years.

The Primary Objective of Strategy is to achieve a Sustained

Competitive Advantage which in turn results in Superior Profit and
Profit Growth.
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 Competitive Advantage, Value Creation,
and Profitability
How profitable a company becomes depends
on three basic factors:
1. VALUE or UTILITY the customer gets from
owning the product
2. PRICE that a company charges for its
products
3. COSTS of creating those products
 Consumer surplus is the “excess” utility a
consumer captures beyond the price paid.
Basic Principle: the more utility that consumers get
from a company’s products or services, the more
pricing options the company has.
Copyright © Houghton Mifflin Company. All rights reserved. 3 | 10
 Value Creation per Unit
Figure 3.2

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 Comparing
Toyota and General Motors
Figure 3.4

Superior value creation requires that the gap between

perceived utility (U) and costs of production (C)
be greater than that obtained by competitors.
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 The Value Chain
(addition of utility)
With the goal of competitive strategy of cost leadership or/and
product differentiation a company is a chain of activities for
transforming inputs into outputs that customers value –
including the primary and support activities.

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 Zara
 Spain’s fastest growing and most successful fashion house with $8.5
billion sales and network of 2800 stores in 64 countries. Why?
 Speed: Most fashion houses take 6-9 months to go from design to
having merchandise delivered to store that Zara takes 5 weeks
 Unlike most houses involved in outsourcing Zara has its own factories,
designers and stores. These designers are in constant touch with
stores, They talk weekly with store managers to know about what goes
hot now. Zara designers annually creates 40,000 new designs from
which only 10,000 are selected for production.
 Technology of production is both capital and labor intensive. It makes
use of computer controlled machinery to cut pieces of garments and
use of labor for sewing. Usually it produces not in large volume but it
has surplus capacity that is utilized once demanded in any particular
line.
 Once garments has been made, it is delivered to its store once a
week. Zara deliberately under produces its products that gives a signal
to customers that they must get it fast before it ends. So it creates
scarcity value.
 This requires Zara only to maintain 10% inventory of sales compared
to 15 % of the industry average. This means fewer price reductions to
move products if not sold.
 Building Blocks
of Competitive Advantage
The Generic
 Figure 3.6
Distinctive Competencies
Allow a company to:
• Differentiate product offering
• Offer more utility to customer
• Lower the cost structure
regardless of the industry,
its products, or its services
 

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Sources of Competitive Advantage  Efficiency

 Measured by the quantity of inputs it takes to produce a given

output:
Efficiency = Outputs / Inputs
 Productivity leads to greater efficiency and lower costs:
• Employee productivity (30 hours for GM to assemble a car
shows less employee productivity than Ford that takes 25 hours)
• Capital productivity (Dell generated $12.07 sales for every dollar
capital it invested in business in 2005 compared to $2.14 of HP.)
• Branch productivity (Deposit and advances of urban vs. rural
branch of bank of Bangladesh)
• R&D productivity is important for pharmaceuticals that indicate
the number of new drugs (output) per dollar of R&D.

Superior efficiency helps a company attain a competitive

advantage through a lower cost structure.

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Sources of Competitive Advantage  Quality
Quality products are goods and services that are:
• Attributes to physical products are form, features,
performances, durability, reliability, style and design
• Differentiated by attributes that customers perceive to have
higher value (specialty of Rolex for example)
The impact of quality on competitive advantage:
• High-quality products differentiate and increase the value
of the products in customers’ eyes. Why do Adidas Charge
high?
• Greater efficiency and lower unit costs are associated with
reliable products.
Superior quality = customer perception of greater
value in a product’s attributes indicates higher
consumer surplus (Like Toyota car)

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 Sources of Competitive Advantage  Innovation

Innovation is the act of creating new products or new

processes
• Product innovation
» Creates products that customers perceive as more valuable
and
» Increases the company’s pricing options
• Process innovation
» Creates value by lowering production costs

Successful innovation can be a major source of

competitive advantage – by giving a company
something unique, something its competitors lack.

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 Sources of Competitive Advantage
 Responsiveness to Customers
Identifying and satisfying customers’ needs –
better than the competitors
 Superior quality and innovation are integral to superior
responsiveness to customers.
 Customizing goods and services to the unique demands of
individual customers or customer groups.
 How to enhance customer responsiveness
 Queue Theory
 How long time taken by a bank to process a loan or to encash a
cheque or to open an account
 Customer response time, design, service, after-sales service
and support (Zara is quick to respond any change in customers
demand for fashion). Slow response time is a major source of
customers’ dissatisfaction.
Superior responsiveness to customers differentiates a company’s
products and services and leads to brand loyalty and premium pricing.
Copyright © Houghton Mifflin Company. All rights reserved. 3 | 19
 Analyzing Competitive
Advantage and Profitability
 Competitive Advantage
• When a companies profitability is greater than the average of all
other companies in the same industry that compete for the same
customers
 Benchmarking
• Comparing company performance against that of competitors and
the company’s historic performance

 Measures of Profitability
• Return On Invested Capital (ROIC)
• Net profit
= Net income after tax
ROIC = Capital invested
Equity + Debt to creditors

• Net Profit = Total revenues – Total costs

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 20
 Definitions of
Basic Accounting Terms
Table 3.1

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 Drivers of Profitability (ROIC)
Figure 3.9

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 Financial
Statements
Analysis, and
Projection
 Balance Sheet: Assets

2005 2004
Cash $ 15.0 $40.0
A/R 180.0 160.0
Inventories 270.0 200.0
Total CA $ 465.0 400.0
Gross FA 680.0 600.0
Less: Dep. (300.0) (250.0)
Net FA 380.0 350.0
Total Assets $845.0 $750.0
 Balance sheet:
Liabilities and Equity
2005 2004
Accts payable $30.0 15.0
Notes payable 40.0 35.0
Accruals
60.0 55.0
Total Current Liabilities
Long-term debt $130.0 $105.0
Total Liabilities 300.0 255.0
Common stock $430.0 $360.0
Retained earnings 130.0 130.0
Total Equity 285.0 260.0
Total Liabilities & Equity $415.0 $390.0
$845.0 750.0
 Income statement
2005 2004
Sales $1500.0 $1435.0
COGS (1,230.0) (1,176.7)
Other expenses (90.0) (85.5)
EBITDA 180.0 173.3
Depr. & Amort. (50.0) (40.0)
EBIT $130.0 133.3
Interest Exp.
(40.0) (35.0)
Taxable income
$90.0 $98.3
Taxes (40%)
(36.0) (39.3)
Net income
Common Dividends $ 54.0 $59.0
(29.0) (27.0)
 Other data

2005 2004
Shares outstanding 25 million 25 million
EPS $2.16 $2.36
DPS $1.16 $1.08
Stock price $25.00 $23.00
 Statement of Retained Earnings
(2005)

Balance of retained earnings, 12/31/04 $260

Add: Net income, 2005 54
Less: Dividends paid (29)
Balance of retained earnings, 12/31/05 $285
Methods of Ratio analysis

Bench mark analysis

Time series analysis
Cross section analysis
What are the five major categories of ratios, and
what questions do they answer?

 Liquidity: Can we make required payments?

 Asset management: right amount of assets vs.
sales?
 Debt management: Right mix of debt and
equity?
 Profitability: Do sales prices exceed unit costs,
and are sales high enough as reflected in PM,
ROE, and ROA?
 Market value: Do investors like what they see
as reflected in P/E and M/B ratios?
 Ratio analysis
Ratio 2005 2004 Industry Comment
More funds available for
1. Current 3.6 3.8 4.1
investment
2. Quick 1.5 1.9 2.1 Do
3. Inventory 4.6x 5.9x 7.4x Inventory piled up in an
Turnover. inflationary economy
4. DSO 43.2 40.7 32.0 Aggressive sales campaign
(receivable/daily
sales)
5. FA TO 3.9x 4.1x 4.0x Sales deferred for next year
6. TA TO 1.8x 1.9x 2.0x Do
7. Debt Ratio 50.9% 48% 45% High gearing of EPS
Total debt/assets expected
8. TIE 3.3 x 3.8x 6.5x It would increase in future
 Ratio analysis (Contd..)
Ratio 2005 2004 Industry Comment
9. Profit (54/1500) (59/1435) Inventory procurement
4.1% 4.7%
Margin 3.6% reduced Profit
(54/845) (59/750) Both fixed assets and
10. ROA 9.5%
6.4% 7.87% inventory procured
(54/415) (59/390) Equity base has gone up
11. ROE 17.2%
13.0% 15.1%
12. Market: ($25/$16.6) ($23/$15.6)
2.0 Investors like the strategy,
Book ratio =1.5 x = 1.7x price of share has gone up
13. P:E ratio $25/$2.16 $23/$2.36 13.0x Trust of investors has gone
=11.6x =9.7x up.
The Sustainable Growth Rate in Sales
D
p  (1  d )  (1  )
gs  E
D
T  ( p  (1  d )  (1  ))
E

T =Ratio of total assets to sales

p =Net profit margin on sales
d =dividend payout ratio
54 29 130  300
* (1  ) * (1  )
gs  1500 54 130  285  0.064
845  54 29 130  300 
 * (1  ) * (1  )
1500 1500 54 130  285 
 Forecasting with different ‘g’
Current following following
year Next year year year 2008 next year Contextual next
Current (2005) 2006 gs 2007 gs gs g=20% year
Sales 1500 1596. 1698. 1807.43 1800 1597
Net Income 54 57.46 61.14 65.06 64.8 81
Dividend (Current 29/54) 29 30.85 32.84 34.94 34.80 43.50
Addition to retained earnings 25 26.60 28.31 30.12 30.00 37.50
Total assets 845 899.2 956.8 1018.1 1014 870
Total Debt 430 457.5 486.8 518.10 516 458
Common stock 130 130 130. 130.00 130 130
Retained earnings 285 311. 339.9 370.03 315.0 322.50
Total Financing 845 899.1 956.8 1018.14 961.0 910.50
Funds needed 0 -0.001 0.00 0.00 53.00 -40.50
Debt: Equity ratio 1.04 1.04 1.04 1.04 1.28 .92
Sustainable Growth Rate 0.0641 0.064 0.064 0.064 0.072 0.095

34
 Notes:
With a single growth rate of sales, as well as, of all the
cost and current liability and long term liability there
remains following constraints:
• Higher growth of sales is not sustainable
• Floatation of new shares is not a variable
• Addition to retained earnings depends on net income
as well as payout ratio
• Assets would be automatically financed by sales at the
sustainable growth rate. So leverage remains constant.
To finance assets needed for higher growth of sales,
External Funds Needed (EFN) should be identified that
often raises further debt and increases the Debt:
Equity ratio. So leverage can not be constant.
• At any other rates of growth of sales, if leverage is
constant then dividend policy can not be fixed.
 Increasing the Sustainable
Growth Rate
A firm can do several things to increase its
sustainable growth rate:
• Sell new shares of stock
• Increase its reliance on debt
• Reduce its dividend-payout ratio
• Increase profit margins
• Decrease its asset-requirement ratio
Contextual Forecasting: Since the firm piled up inventories and fixed assets, we suppose,
the firm is already prepared to finance higher sales in the next year. So, we keep these
away from growth. Assume: gs=6.5%. Does this explain increase in share price?
Sales 1597
COGS (only 50% of direct cost follows growth)
[{(1230/2)+90+50+40)}*1.065]+[1230/2] 1462
Taxable income 135
Net Income 81
Dividends 43
Addition to Retained earnings 38
Current assets (without increase in inventories) 478
Fixed assets (Only half of Fixed assets has increased) 392
Total assets 870
Total debt 458
Equity (Common stock +Retained Earnings) 453
Total financing 910
Funds needed (This is negative debt or lending) -40
Debt: Equity 0.92
Growth 0.094520
 Comment on contextual analysis
The firm is better prepared for growth of
sales in the next year by means of higher
acquisition of inventory and fixed assets.
This may results in higher income of $81m.
against the normal income of $57m. for the
next year. Sustainable growth rate of the
firm would increase to 9.5% from the next
year against the current one of 6.5%. This
may be known to investors and might be
the reason for increased share price.
Prediction of Distress and Turnaround

 Models for distress prediction

• Several models to predict distress have been developed over the
years. One of the more popular and robust models is the Altman’s
Z-score model:

 Bankruptcy prediction when Z is less than 1.2,

 Z within the range between 1.2 and 2.9 is gray area.
 Z above 3 is safe.
 Calculation of Z score
X1 Net working (465-130)/845 0.4 (400-105)/750 0.39
capital/Total assets

X2 Cumulative retained 285/845 0.34 260/750 0.35

earnings/Total
assets
X3 EBIT/Total Assets 130/845 0.15 133/750 0.18
X4 Market value of equity/ (25*25)/ (845-415) 1.45 (25*23)/(750-390) 1.6
Total liabilities
X5 Sales/Total Assets 1500/845 1.78 1435/750 1.91
Z2005=(1.2*0.4)+(1.4*0.34)+(3.3*0.15)+(0.6*1.45)+(1.78)=3.4
Z2004=(1.2*0.39)+(1.4*0.35)+(3.3*0.18)+(0.6*1.6)+(1.91)=4.4
Comment: The firm is safe. The score decreased in 2005 against 2004.
The investors had not taken that under consideration as the scores
are above the hurdle of 3 and so stock price has rather gone up.
 Problem 2:
Off-balance sheet financing
Income Statements Figures in million taka
2009 2008
Sales 1870 1500
COGS -970 -900
Gross Profit 900 600
Fixed operating exp. -350 -300
Depreciation -120 -80
EBIT 430 220
Interest -100 -30
EBT 330 190
Tax (30%) -99 -57
Net income 231 133
 Other information
Net income for common stockholders
(Tk in million) 231 133
Common dividends (Tk in million) 100 80
Addition to retained earnings (Tk in million) 131 53
Book value per share (Tk) 1,368 1,106
EPS (Tk) 462 266
DPS (Tk) 200 160
Market price per share (Tk) 990 1,020

Question: Share price has gone down, although sales

increased, net income (EPS) increased, DPS increased,
retention and equity increased. Why?
 Balance Sheet: Assets
Assets 2009 2008 Revised (2009)
Cash 65 45 65
Accounts receivable 170 100 170
Inventory 150 70 150
Total current assets 385 215 385
Gross plant and equipment 1000 705 1450
Accumulated depreciation -240 -120 -240
Net Plant & Equipment 760 585 1180
Total assets 1145 800 1595
• Increased net plant and equipment is just equal to the amount
of off-balance sheet financing (see next slide).
 Balance Sheet: Liabilities & Equity
Liabilities 2009 2008 Revised (09)
Accounts payable 155 90 155
Accruals 43 27 43
Notes payable 33 30 33
Total current liability 231 147 231
Long term bond 230 100 650
Total liabilities 461 247 881
Common stock (500,000) 500 500 500
Retained earnings 184 53 184
Owners' equity 684 553 684
Total liability & equity 1145 800 1595
 Revised long term debt: i=12%. Interest increased by 70 refers to new debt
of 583. Out of that, B/S increase of debt is 133, i.e., (33+230)-(30+100). Rest
of the increase in debt might be the off-balance sheet financing like 450=
(583-133).
 Calculation of Z- Score
Revised
2009 2008 2009
X1 Net working capital/Total assets 0.13 0.09 0.10
X2 Cumulative retained earnings/Total assets 0.16 0.07 0.12
X3 EBIT/Total Assets 0.38 0.28 0.27
X4 Market value of equity/ Total liabilities 1.07 2.07 0.54
X5 Sales/Total Assets 1.63 1.88 1.17
Z Score 3.489 3.71 2.40
•Comment on Financial Distress: The firm is in financial distress as Z-
score is below 3 if off-balance sheet financing is converted in to debt
financing. Investors can not be fooled by that. Hence, price has gone
down as the firm goes through distress although sales, income, EPS,
DPS, equity increased.
 Practice: Test Case
 Following is the information of income statements, balance sheets, and
different ratios of Tiny Crafts involved in the production of low-cost solar
system for the years of 2008 and 2009.
• Make a performance analysis of the firm by the help of cash flow and
ratio analysis with particular emphasis on DuPont method. What is the
sustainable growth rate and consequential EFN, Debt: Equity ratio and
forecasted stock price for next couple of years? What would happen if
sales grow at 30% rate in the next year in an optimistic case and decline
20% in the pessimistic case? Compare this with the situation of current
sustainable growth.
• In the new budget the government has withdrawn considerable extent of
tariffs that increased the competitiveness of the sector. This would
result in the change of current unit price of the commodity from
Tk.20,000 to Tk.15,000 in the next year (although we are not involved in
import). Of course, sales volume would increase from the current level
of 154 to 175 in the next year. COGS is in general consistent with sales
but due to excess procurement of inventory in the current year (in
anticipation of increased price) around half of COGS is insensitive. Also
consider that short term interest rate would increase by 10% as the
government is contemplating to introduce the 10% vat on that. Besides,
capacity utilization of fixed assets is 70% at present suggesting that no
new assets would be needed for the next year.
 Balance Sheet: Assets
Figures in thousands
Assets 2009 2008
Cash Tk.80 Tk.70
Accounts receivable Tk.110 Tk.100
Inventory Tk.450 Tk.300
Total current assets Tk.640 Tk.470
Gross plant and equipment Tk.620 Tk.450
Accumulated depreciation Tk.120 Tk.80
Net Plant & Equipment Tk.500 Tk.370
Total assets Tk.1,140 Tk.840
 Balance Sheet : Liability
Figures in thousands
Liabilities 2009 2008
Accounts payable Tk.140 Tk.70
Accruals Tk.61 Tk.55
Notes payable Tk.150 Tk.60
Total current liability Tk.351 Tk.185
Long term bond Tk.74 Tk.60
Total liabilities Tk.425 Tk.245
Common stock
(5,000 shares of Tk.100 each) Tk.500 Tk.500
Retained earnings Tk.215 Tk.95
Owners' equity Tk.715 Tk.595
Total liability & equity Tk.1140 Tk.840
 Income Statements
Figures in thousands
2009 2008
Sales Tk.3,080 Tk.2,800
COGS Tk.2,360 Tk.2,220
Gross Profit Tk.720 Tk.580
Fixed operating exp. Tk.225 Tk.175
Depreciation Tk.40 Tk.30
EBIT Tk.455 Tk.375
Interest Tk.55 Tk.30
EBT Tk.400 Tk.345
Tax (40%) Tk.160 Tk.138
Net income for common stockholders Tk.240 Tk.207
Common dividends Tk.120 Tk.112
Share price (Absolute amount) Tk.167 Tk.180
 Cash flow statement (Approach 1) Amount
Operating Activity: Net income (Source) 240
Add depreciation (Source) 40
Less increase in current assets: Receivables (Use) 10
Less increase in current assets: Inventory (Use) 1501
Add decrease in current liabilities: Accounts payable (Source) 702
Accruals (Source) 6
Net cash from operation (Source) 1963
Financing activity: Notes payable (Source) 904
Bond (Source) 14
Dividends (Use) 1205
Total from financing -16
Investment activity: Increase in net fixed assets (Use) -1706
Net change in cash 10
Opening cash balance 70
Closing cash balance 80
 Comment on Cash Flow Analysis
(Approach 1)
 1. Inventory was piled up in anticipation of price
increases of raw materials and finished products. But
as it turned up, price went down due to withdrawal of
tariffs. This represents hidden loss as price gone down
 2. Credit purchase might be a motivation to pile up
inventory.
 3. Operating cash flow is less than net income
 4. Abnormal increase in short term bank loan rather
than long term debt is risky as that holds variable
interest. In fact, the same happened as the govt.
increased interest rate.
 5. Loan taken to pay dividends
 6. Abnormal increase in fixed assets consumed cash.
 Cash Flow Statement: Approach 2
EBIT 455
Add depreciation 40
Less tax 160
Operating cash flow (Source of cash) 335
Capital spending:
Ending net fixed investment 500
Less beginning fixed investment 370
Add depreciation 40
Net fixed investment (Use of cash) 170
Changes in net working capital:
Ending net working capital 289
Less beginning net working capital 285
Changes in net working capital (Use of cash) 4
 Cash Flow Statement: Approach 2
Free Cash flow from assets (Contd.)
Operating cash flow (Source of cash) 335
Net fixed investment (Use of cash) 170
Changes in net working capital (Use of cash) 4
Free cash flow (Source) 161
Cash flow to creditors
Interest paid (Uses) 55
Less new long term borrowing (Source) 14
Cash flow to creditors (Use) 41
Cash flow from investors
Dividend paid 120
New equity 0
Cash flow to investors (Use of cash) 120
 Comments of cash flow statement
(Approach 2)
 Operating cash flow is Tk.335 thousands against the net
income of Tk.240 thousands.
 Increase in investment is as a bit high like Tk.170 thousands.
 Increase in net working capital is only Tk.4 thousands
indicating a moderate degree of growth.
 Free cash flow is Tk.161 thousands.
 Cash flow to creditors is Tk.41 thousands net. Payment of
interest is Tk.55 thousands and new loan taken is Tk.14
thousands. There might be an indication of lease financing as
the total debt (long term and notes payable) is Tk.224 and the
interest payment is Tk.55 thousands.
 Cash flow to investor is Tk.120 thousands which is exclusively
made of dividend payments. If the firm is a believer of
relevancy of dividend policy and thus makes attempt to
increase stock price by paying high dividends, then it was not
successful as the stock price rather went down.
 Pro forma Income Statements
Y1 Y1 Y1
current Y1 Y2 Optimistic Pessimist (context)
Growth of sales 20% 20% 30% -20% -14.77%1
Sales 3,080 3,696 4,435 4,004 2,464 2,625
Cost 2,680 3,216 3,859 3,484 2,144 2,4782
Taxable Income 400 480 576 520 320 147
Tax (40%) 160 192 230 208 128 59
Net Income 240 288 346 312 192 88
Dividend (50%) 120 144 173 156 96 44
Addition to
Retained earng. 120 144 173 156 96 44
 Pro forma Balance sheet & Forecasting
Y1
Current Y1 Y2 Y1Optimistic Y1 Pessimistic (context)
Current assets 640 768 922 832 512 545
Fixed assets 500 600 720 650 400 426
Total assets 1,140 1368 1642 1482 912 972
Total Debt 425 510 612 553 340 362
Common stock 500 500 500 500 500 500
Retained earnings 215 359 532 371.0 311.0 259
1,36 1,64
Total Financing 1,140 9 4 1,424 1,151 1,121
Increase in assets 228 276 342 -228 -168
Funds needed 0.0 0.0 59 -239 -150
Debt: Equity ratio 0.59 0.59 0.59 0.70 0.12 0.28
growth 0.202 0.20 0.20 0.22 0.13 0.06
EPS 48.0 57.7 69.1 62.4 38.4 17.7
P:E 3.5 3.5 3.5 3.5 3.5 3.5
 Notes of contextual forecast
 1: Expected sales of next year=15*175=Tk.2,625,
Current sales=20*154=Tk.3,080. The rate of change is
negative 14.77%.
 2. Calculation of the cost of Tk.2,478:
 COGS=(2,360/2)+((2,360/2)*(1-.14.8))=2,186
 Fixed operating expenses=225*(1-.148)=192
 Depreciation unchanged as no new fixed
investment =40
 Interest increases by 10%=(55*1.1)=60
 Problem 3: Capital Investment
Decision: (SEC)
 Solar Electronics Corporation (SEC) has recently
developed the technology for solar powered jet engines.
Cost of capital is 15%.The investment will cost $1500
million. Production will occur over the next 5 years. Annual
sales would be 30% of the market of 10,000. Sales price
is $2 million per unit and variable costs are $1 million per
unit. Fixed costs estimated are $1,791 million. The
following table represents other possibilities as well. Find
out the NPVs under different situation.
 The current market price per share is $645. Number of
shares outstanding are 150 million. The firm holds a
growth rate of 3% annually. What would be the your
prediction of share price of the next year assuming the
project is accepted and expected scenario prevails?
 Problem 3: Scenario Analysis
Pessimistic Expected Optimistic
Market size 5,000 10,000 20,000
Market share 20% 30% 50%
Price (in million dollar) 1.9 2 2.2
Variable cost in $m (per plane) 1.2 1 0.8
Fixed cost (per year) $m 1891 1791 1741
Investment $m 1900 1500 1000
Ke 12% 15% 17%
NPV
Market size -1802 1517 $8,154
Market share -695 1517 5942
Price (in million dollar) 853 1517 2844
Variable cost in $m(per plane) 189 1517 2844
Fixed cost (per year) $m 1,295 1517 1627
Investment $m 1208 1517 1903
Ke 1744 1517 1379
 Worksheet: Problem 3
Y0 Y1-5
Investment -1500
Sales (No) 3000
Revenue 6000
TVC -3000
FC -1791
Depreciation -300
Pretax Profit 909
Tax (.34) 309.06
Net profit 599.94
Annual Cash Inflow 899.94
PVIFA (i=.15,n=5) 3.352155
PV (Cash Inflow) 3017
NPV 1517
 Prediction of share price

Current market capitalization in million

dollar 645*150 96,750

Market capitalization of the next year

assuming 3% growth 96750*1.03 99652.5
Market capitalization including the
project 99652.5+1517 101169.5

Share price of the next year in dollar 101169.5/150 674.46

 Problem 3: Scenario 2: Investment life
is different from project life
 It turns up that the life of investment is different from the
life of the project. If the life of the investment (in machine)
is 10 years and the market value of the investment at the
termination of the project is $500 million. How would that
affect the expected share price next year?
Investment life is 10 years and market salvage value is $500m:
NPV and stock price of next year
Y0 Y1-5 Calculation of NSV $m
Investment -1500 Cost of Investment 1500
Sales (No) 3000 Depreciation (Life 10 years) 150
Revenue 6000 Accumulated depreciation 750
TVC -3000 Book value 750
FC -1791 Market value 500
Depreciation -150 profit/(loss) -250
Pretax Profit 1059 tax Savings -85
Tax (.34) 360 NSV5 585
Net profit 699 PV(NSV0 )=(585/(1.15)^5)= 291
Annual Cash Inflow 849
PVIFA (i=.15,n=5) 3.352
PV of NSV 291
PV (Cash Inflow) = (1849*3.352155)+291=3137
NPV =1637 P1=(99652.5+1637)/150=$675.26

63
 Problem 3. Scenario 3:
Delay of investment
Suppose the SEC has a new CEO who predicts a decline of machine price of
investment annually by 20%, and accordingly, decided to delay the investment
by 3 years from the next year. What would be the stock price next year then?
Step 1: Find the investment amount and time: Right here investment is delayed
for 3 years and that goes down @20% annually. So Investment amount arrives
at 1500*(1-.2)*(1-.2)*(1-.2)=$768m and takes place at Year 3.
Step 2: Find out the amount of annual depreciation which is $768m/5 =
$153.6m.
Step 3. Arrive at the NPV which is of 3rd year. The NPV is $2,082 m.
(Calculation shown in the next slide.)
Step 4: Convert the NPV to that of next year. As you divide the NPV of $1,369
m. by (1+k)3 the NPV becomes that of the next year which is the appropriate
NPV to be added to market capitalization of the company of the next year.

64
 NPV and P1 of Delayed case
Investment ($ in million) -768
Market size 10000
Market Share 30%
Sales (No) 3000
Revenue ($ in million) 6000
TVC ($ in million) -3000
FC ($ in million) -1791
Depreciation ($ in million) -154
Pretax Profit ($ in million) 1055
Net profit ($ in million) 697
Annual Cash Inflow ($ in million) 850
NPV3 ($ in million) 2082
NPV0 ($ in million) 1369
P1 (absolute amount) $ 673.47
65
 The Durability of Competitive Advantage
The DURABILITY of a company’s competitive advantage over its
competitors depends on:
1. Barriers to Imitation
Making it difficult to copy a company’s distinctive competencies
 Imitating Resources (GM in 1920s imitated Ford’s assembly line manufacturing,
Toyota has strong defense as it does not give such access to its latest equipments.)
 Imitating Capabilities or intangibles like brand that law prohibits in cases, marketing
skills can be easily imitated, (Coke followed Diet Pepsi), and technological know
how can be imitated if not protected by patents (for 20 years) or lack of law
enforcement.
2. Capability of Competitors
 Strategic commitment
Commitment to a particular way of doing business (US car industry in 1945-1975 of
oligopoly of GM, Ford and Chrysler was so committed to large cars that it failed to
adopt the new technology of small fuel efficient car introduced by Toyota in 1970s.)
 Absorptive capacity
Ability to identify, value, assimilate, and use knowledge (GM was such bureaucratic
and inward looking firm that it failed to identify, value, assimilate, and use to
knowledge adopt Toyota strategy of lean production system)
3. Industry Dynamism: Ability of an industry to change rapidly

Competitors are also seeking to develop distinctive competencies that will give
Copyright © Houghton Mifflin Company. Allthem a competitive edge.
rights reserved. 3 | 66
 Why Companies Fail
 Inertia: Companies find it difficult to change their strategies and structures. (Ex. IBM, GM,
American Express, Digital Equipment, and Sears were once the example of managerial
excellence but then have gone through financial distress. IBM lost $5b in 1992 leading a
layoff of 100,000 employees. IBM always emphasized on close coordination and consensus
among operating units, an advantage that turned disadvantage when faster decision making
was needed )
 Prior Strategic Commitments: Limit a company’s ability to imitate and cause competitive
disadvantage. (The dramatic decline in the cost of computing power as a result of innovations
in microprocessor challenged IBM due to its prior large scale investment in main frame.)
 The Icarus Paradox: Danny Miller coined the word to refer to the situation where a company
becomes so specialized and inner directed based on past success that it loses sight of market
realities
• Categories of rising and falling companies as Miller pointed out that:
• Craftsmen (technical success of Texas Instrument in engineering excellence lost focus
on market realities.)
• Diversification (Success in diversification of Amazon. COM and builders like Gulf and
Western ignored the limit to stop diversification)
• innovation (Wang Labs Pioneer innovator obsessed with that not focusing the market)
• Salespeople (Over impressed by sales capability of Proctor & Gamble ignored product
development.)

When a company loses its competitive advantage, its profitability falls below that of the industry.
It loses the ability to attract and generate resources.
. Profit margins and invested capital shrink rapidly. 3 | 67
 Avoiding Failure:
Sustaining Competitive Advantage
1. Focus on the Building Blocks of Competitive
Advantage
Develop distinctive competencies and superior performance in:
 Efficiency  Quality
 Innovation  Responsiveness to Customers
2. Institute Continuous Improvement and Learning
Recognize the importance of continuous learning within the organization
3. Track Best Practices and Use Benchmarking
Measure against the products and practices of the most efficient global
competitors
4. Overcome Inertia
Overcome the internal forces that are barriers to change
Luck may play a role in success,
so always exploit a lucky break - but remember:
“The harder I work, the luckier I seem to get.” J P Morgan

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 68