Strategy and Owners’ Wealth Maximization Often firms conceptualize a strategy in terms of the consumers of the

Strategy and Owners’ Wealth Maximization Often firms conceptualize a strategy in terms of the consumers of the

firm’s goods and services. For example, you may have a strategy to become the world’s leading producer of microcomputer chips by pro- ducing the best quality chip or by producing chips at the lowest cost, developing a cost (and price) advantage over your competitors. So your focus is on product quality and cost. Is this strategy in conflict with maximizing owners’ wealth? No.

To maximize owners’ wealth, we focus on the returns and risks of future cash flows to the firm’s owners. And we look at a project’s net present value when we make decisions regarding whether or not to invest in it. A strategy of gaining a competitive or comparative advan- tage is consistent with maximizing shareholder wealth. This is because projects with positive net present value arise when the firm has a com- petitive or comparative advantage over other firms.

Suppose a new piece of equipment is expected to generate a return greater than what is expected for the project’s risk (its cost of capital). But how can a firm create value simply by investing in a piece of equip- ment? How can it maintain a competitive advantage? If investing in this equipment can create value, wouldn’t the firm’s competitors also want this equipment? Of course—if they could use it to create value, they would surely be interested in it.

1 Lois Therrien, Patrick Oster, and Chuck Hawkins, “How Sweet It Isn’t At Nutra- Sweet,” Business Week (December 14, 1992), p. 42.

2 Monsanto sold its sweetener division in 2000.

Strategy and Financial Planning

Now suppose that the firm’s competitors face no barriers to buying the equipment and exploiting its benefits. What will happen? The firm and its competitors will compete for the equipment, bidding up its price. When does it all end? When the net present value of the equipment is zero.

Now suppose instead that the firm has a patent on the new piece of equipment and can thus keep its competitors from exploiting the equip- ment’s benefits. Then there would be no competition for the equipment and the firm would be able to exploit it to increase its owners’ wealth.

Consider an example where trying to gain a comparative advantage went wrong. Schlitz Brewing Company attempted to reduce its costs to gain an advantage over its competitors: It reduced its labor costs and shortened the brewing cycle. Reducing costs allow it to reduce its prices below competitors’ prices. But product quality suffered—so much that Schlitz lost market share, instead of gaining it.

Schlitz attempted to gain a comparative advantage, but was not true to a larger strategy to satisfy its customers—who apparently wanted quality beer more than they wanted cheap beer. And the loss of market share was reflected in Schlitz’s declining stock price. 3

Value can only be created when the firm has a competitive or compara- tive advantage. If a firm analyzes a project and determines that it has a posi- tive net present value, the first question should be: Where did it come from?