Chapter 2

Question 1

Profit

Answer 1

Revenue - Cost

Question 2

Producer surplus

Answer 2

Profit - “rents” to input provider

Question 3

Customer surplus

Answer 3

the willingness to pay, or the total value the customer gets from the product/service, not the price it cost.

Question 4

Value creation

Answer 4

consumer surplus + producer surplus
Or
total customer value - Real cost of production

Question 5

Market capitalization

Answer 5

the value of a company that is traded on the stock market, calculated by multiplying the total number of shares by the present share price.

Question 6

ROS= return on sales

Answer 6

operating profit as a percentage of sales revenue.

Question 7

Return on capital employed (ROCE)

Answer 7

Earnings before interest and tax (EBIT) / (Total assets - current liabilities)
ROCE is also known as return on invested capital (ROIC). The denominator can also be measured as shareholders’ equity plus long-term debt.

Question 8

Return on equity (ROE)

Answer 8

Net income / Shareholders’ equity
ROE measures a firm’s ability to use equity capital to generate profits that can be returned to share- holders. Net income may be adjusted to exclude discontinued operations and special items.

Question 9

Return on assets (ROA)

Answer 9

Operating profit (orEBITorEBITDA) / Total assets
The numerator should correspond to the return on all the firm’s assets.

Question 10

Gross margin

Operating margin

Net margin

Answer 10

Sale—Cost of bought-in goods and services / Sales

Operating profit / Sales

Net income / Sales

Question 11

There are three types of profit, what do they mean?
Gross profit

Operating profit

Net profit

Answer 11

sales revenue less (minus) material cost

gross profit less operating expences, before tax/interest

profit after deducting all expenses

Question 12

Economic Profit

Answer 12

Economic profit is pure profit, combining the normal return to capital and the surplus available after all inputs (including capital) have been paid for.
Operating Profit — (WACC x Capital Employed)
WACC = weighted average cost of capital

Question 13

EVA

Answer 13

Economic value added

Question 14

What is Cash flow?

Answer 14

There are two types of cash flow:
Operating Cash Flow: The cash generated by the firm’s operations.
Free Cash Flow: Operating cash flow less capital investment.

Question 15

What is the strategic goal of a business?

Answer 15

The strategic aim of a business is to earn a return on capital. However, there is a debate over the appropriate goals for business enterprises. Some argue that the primary goal is to maximize shareholder value, while others believe that the firm should operate in the interests of all its stakeholders.

Question 16

How does companies create value for their customers?

Answer 16

The purpose of business is to create value for customers. Value can be created in two ways:

Production: physically transforming products that are less valuable into products that are more valuable.
Commerce: repositioning products in space and time to increase their value.

Question 17

Value for Whom?

Answer 17

The value created by a firm is distributed among different parties:
Customers: receive consumer surplus
Owners: receive profits
Employees and input owners: receive rents (excess earnings)

Question 18

What are two approaches to value creation?

Answer 18

Stakeholder value maximization: the firm should operate in the interests of all its stakeholders, maximizing total value creation.
Shareholder value maximization: the firm should operate in the interests of its owners, maximizing profits.

Question 19

What are the problems with Pursuing stakeholder interests?
(maximizing total value creation and ensuring its equitable distribution among stakeholders)

Answer 19

Measuring performance: estimating the components of value creation is near impossible.
Balancing stakeholder interests: prioritizing the interests of different stakeholders can be challenging.

Question 20

What is The Primary Goal of Strategy?

Answer 20

To provide simplicity and clarity to our analysis of firm strategy, we assume that the primary goal of strategy is to maximize the value of the enterprise through seeking to maximize profits over the long term.

Question 21

What are the Justifications for Focusing on Profit Maximization?

Answer 21

Competition: Competition erodes profitability. To survive, a firm must earn a rate of profit that covers its cost of capital over the long term.

Threat of Acquisition: Management teams that fail to maximize profits tend to be replaced by teams that do. Companies that underperform financially suffer a depressed share price, attracting acquirers.

Convergence of Stakeholder Interests: There is likely to be more community of interests than conflict of interests among different stakeholders. Profitability over the long term requires loyalty from employees, trusting relationships with suppliers and customers, and support from governments and communities.

Question 22

Enterprise Value

Answer 22

Enterprise value is equal to the market capitalization of equity plus the market value of debt.
Market Capitalization of Equity + Market Value of Debt

Maximizing the value of the firm (enterprise value) is equivalent to maximizing the present value of the firm’s profits over its lifetime

Question 23

Appraising Current and Past Performance

Answer 23

Appraising current and past performance is the first task of any strategy formulation exercise. This involves identifying the current strategy of the firm and assessing how well that strategy is doing in terms of the performance of the firm.

Question 24

Forward-Looking Performance Measures: Stock Market Value:
What is Stock Market Value?

Answer 24

Stock Market Value: The best available estimate of the Net Present Value (NPV) of future cash flows (net of interest payments).

To evaluate the performance of a firm in creating value, we can compare the change in the market value of the firm relative to that of competitors over a period (preferably several years).

Question 25

Backward-Looking Performance Measures: Accounting Ratios
What is Accounting Ratios?

Answer 25

Accounting Ratios: Historical measures of performance that use financial reports to assess a firm’s effectiveness in generating profits from its assets.

Question 26

Disaggregating Return on Assets:

Answer 26

Breaking down return on assets into its component parts to identify the sources of poor performance.

Question 27

Components to look at during a performance diagnosis.

Answer 27

Sales Margin: Measures the extent to which a firm adds value to the goods and services it buys in.
Asset Turnover: Measures a firm’s ability to extract profit from its sales.
Fixed Asset Turnover: Measures a firm’s ability to extract profit from its fixed assets.
Inventory Turnover: Measures a firm’s ability to extract profit from its inventories.
Creditor Turnover: Measures a firm’s ability to extract profit from its creditors.

Question 28

Performance targets are measurable goals to reach that align with the companys’ strategy. What are the three main approaches to setting performance targets?

Answer 28

Financial Disaggregation: Breaking down financial goals into smaller, more manageable targets.

Benchmarking: Comparing a firm’s performance to that of its competitors or industry averages.

Balanced Scorecard: Using a combination of financial and non-financial measures to evaluate a firm’s performance.

Question 29

What is Performance Management?

Answer 29

Performance management is a systematic process of setting goals, measuring performance, and providing feedback to employees. The goal of performance management is to align individual performance with organizational goals and objectives.

Question 30

What is a Balanced Scorecard?

Answer 30

A balanced scorecard is a strategic management tool that helps organizations achieve their goals by measuring performance from four different perspectives:
Financial Perspective: How do we look to shareholders?
Measures: cash flow, sales growth, return on equity
Customer Perspective: How do customers see us?
Measures: new products, on-time delivery, defect and failure levels
Internal Business Perspective: What must we excel at?
Measures: productivity, employee skills, cycle time, yield rates, quality and cost measures
Innovation and Learning Perspective: Can we continue to improve and develop?
Measures: new product development cycle times, technological leadership, rates of improvement

Question 31

Strategic profit drivers are the key factors that drive profit in an organization. By focusing on these drivers, organizations can create value for shareholders and other stakeholders.

What are some strategic profit drivers?

Answer 31

Obliquity
Obliquity is the idea of pursuing goals indirectly. Instead of focusing on profit directly, organizations should focus on the strategic factors that drive profit.
Corporate Social Responsibility
Corporate social responsibility refers to the idea that businesses have a responsibility to society beyond just making a profit.
Values and Principles
Values and principles are the guiding principles that shape an organization’s culture and behavior.

Question 32

what is the 7S framework?

Answer 32

Strategy: The organization’s overall plan and direction
Structure: The organization’s design and architecture
Systems: The organization’s processes and technology
Skills: The organization’s human resources and capabilities
Style: The organization’s culture and leadership style
Staff: The organization’s employees and human resources
Shared Values: The organization’s core values and principles

Question 33

What is Corporate Social Responsibility (CSR)?

Answer 33

CSR refers to a company’s efforts to improve social, environmental, and economic impacts.
Firm as Property View: The primary responsibility of a business is to operate in the interests of shareholders.
Firm as Social Entity View: A company has a broader responsibility to its stakeholders, including employees, customers, and the environment.

Question 34

What is the Definition of Real Options?

Answer 34

“A real option is the right, but not the obligation, to undertake a particular business initiative or investment.”

Question 35

what are the Types of Real Options?

Answer 35

Growth Options: The option to expand or replicate a business if it is successful.
Abandonment Options: The option to abandon a project if it is not successful.

Question 36

How does companies Create Real Options?

Answer 36

Firms can create real options by:
Making small initial investments in a number of future business opportunities.
Designing projects and plants that permit adaptation to different circumstances.
Introducing decision points at multiple stages, where the main options are to delay, modify, scale up, or abandon the project.

Question 37

Real Options in Strategy Formulation

Answer 37

Real options can be used to:
Enhance the creation of both social and shareholder value.
Create enterprise value not only by generating profit but also by creating real options.
Inform strategy formulation by providing a framework for evaluating investment opportunities.