Strategic Finance

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Strategic Finance Pre-Course Assignment Q1

(Textbook Pg 44 Question 4)

Which type of business, a software company or an electric utility, would benefit more from improving ROIC than from increasing growth? Why? A lower ROIC business would benefit more from improving ROIC than from increasing growth. On the other hand, a business already earning a higher ROIC can generate more additional value by increasing its growth rate. When ROIC < WACC, increasing growth destroys value. When ROIC > WACC, increasing growth creates value. ROIC = (1 - Tax rate) Price per unit - Cost per unit Invested capital per unit

If a business has competitive advantage, it earns a higher ROIC, becauses it charges a price premium or produces its products more efficiently. In order to build competitive advantage, price premium or cost and capital efficiency (or both) strategies are needed. Let's use IBM is a software company and Singapore Power (SP) as the public utitlity business to illustrate this point. SP provides electricity and gas transmission and distribution, and market support services to over a million industrial and domestic customers in Singapore. SP's cost of obtaining electricity is linked to fuel oil prices. This causes SP to be 'disadvantaged' in cost efficiency as the electricity cost is pegged to fuel oil prices. Due to the 14% increase in average fuel oil price, the electricity tariff will increase by 6.1% or 1.48 cents (S$0.0148) per kWh to 25.58 cents (S$0.2558) per kWh for households. In addition, since it is a government related business, its selling price to the consumers cannot be charged too high. This leads to a lower ROIC as compared to non-government related businesses.

On the other hand, IBM develops and manufactures the industry's most advanced information technologies, including computer systems, software, networking systems, storage devices and microelectronics. It is technology drive and there is customer lock-in on the products sold as after sales...