Thursday, February 16, 2012

Class #6 Highlights

In class #6, we studied the question of how to value the assets of a company. This is a fundamental question. Indeed, acquisitions and divestments are the two most significant decisions any CEO can undertake in guiding firm strategy. Conventional inward thinking suggests that we study the cash flows generated by the asset, the sale value, the replacement cost, or other such metrics in valuing an asset. Our game theory approach was to apply the "it's a wonderful life" rule to determine the strategic value of an asset. 

Under this rule, we study the value of the company with an without the asset. In the case, we showed situations where this analysis leads to the conclusion that an asset can have a negative value. In the case, having excess capacity prevented the smaller firm from undertaking a price cutting strategy without provoking a price war. By shedding the asset, the smaller firm became less threatening and unilateral price cuts were more likely to be tolerated by the larger firm. So long as the small firm had enough remaining capacity to add share, these price cuts were, in fact, profitable. 

The shedding of assets to seem less threatening to a rival is called the puppy dog ploy. A key part of firm strategy is calculating where the breakeven point is in terms of share grabbing that avoids provoking a costly price war. Even though one might think that excess capacity provides option value, in some circumstances, it can actually reduce a firm's competitive options and thereby destroy value. 

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