10 January 2006

Porter's Diamond of National Advantage (Part II)

The Diamond as a System
  • The effect of one point depends on the others. For example, factor disadvantages will not lead firms to innovate unless there is sufficient rivalry.
  • The diamond also is a self-reinforcing system. For example, a high level of rivalry often leads to the formation of unique specialized factors.
Government's Role

The role of government in the model is to:
  • Encourage companies to raise their performance, for example by enforcing strict product standards.
  • Stimulate early demand for advanced products.
  • Focus on specialized factor creation.
  • Stimulate local rivalry by limiting direct cooperation and enforcing antitrust regulations.
Application to the Japanese Fax Machine Industry

The Japanese facsimile industry illustrates the diamond of national advantage. Japanese firms achieved dominance is this industry for the following reasons:
  • Japanese factor conditions: Japan has a relatively high number of electrical engineers per capita.
  • Japanese demand conditions: The Japanese market was very demanding because of the written language.
  • Large number of related and supporting industries with good technology, for example, good miniaturized components since there is less space in Japan.
  • Domestic rivalry in the Japanese fax machine industry pushed innovation and resulted in rapid cost reductions.
  • Government support - NTT (the state-owned telecom company) changed its cumbersome approval requirements for each installation to a more general type approval.

09 January 2006

Porter's Diamond of National Advantage (Part I)

Classical theories of international trade propose that comparative advantage resides in the factor endowments that a country may be fortunate enough to inherit. Factor endowments include land, natural resources, labor, and the size of the local population.

Michael E. Porter argued that a nation can create new advanced factor endowments such as skilled labor, a strong technology and knowledge base, government support, and culture. Porter used a diamond shaped diagram as the basis of a framework to illustrate the determinants of national advantage. This diamond represents the national playing field that countries establish for their industries.

The individual points on the diamond and the diamond as a whole affect four ingredients that lead to a national comparative advantage. These ingredients are:
  1. The availability of resources and skills,
  2. Information that firms use to decide which opportunities to pursue with those resources and skills,
  3. The goals of individuals in companies,
  4. The pressure on companies to innovate and invest.
The points of the diamond are described as follows:

I. Factor Conditions
  • A country creates its own important factors such as skilled resources and technological base.
  • The stock of factors at a given time is less important than the extent that they are upgraded and deployed.
  • Local disadvantages in factors of production force innovation. Adverse conditions such as labor shortages or scarce raw materials force firms to develop new methods, and this innovation often leads to a national comparative advantage.
II. Demand Conditions
  • When the market for a particular product is larger locally than in foreign markets, the local firms devote more attention to that product than do foreign firms, leading to a competitive advantage when the local firms begin exporting the product.
  • A more demanding local market leads to national advantage.
  • A strong, trend-setting local market helps local firms anticipate global trends.
III. Related and Supporting Industries
  • When local supporting industries are competitive, firms enjoy more cost effective and innovative inputs.
  • This effect is strengthened when the suppliers themselves are strong global competitors.
IV. Firm Strategy, Structure, and Rivalry
  • Local conditions affect firm strategy. For example, German companies tend to be hierarchical. Italian companies tend to be smaller and are run more like extended families. Such strategy and structure helps to determine in which types of industries a nation's firms will excel.
  • In Porter's Five Forces model, low rivalry made an industry attractive. While at a single point in time a firm prefers less rivalry, over the long run more local rivalry is better since it puts pressure on firms to innovate and improve. In fact, high local rivalry results in less global rivalry.
  • Local rivalry forces firms to move beyond basic advantages that the home country may enjoy, such as low factor costs.

08 January 2006

Porter's 5 Forces Model

WTO : get on with it!

Tim Worstall writes:

The New York Times carries an editorial on the Doha Round and trade talks. They are, by the standards of that paper, extremely blunt in their phrasing:

And guess where negotiations have stalled? The European Union and the United States are busily fighting over how little they can get away with when it comes to liberalizing farm trade. Listening to these two economic powerhouses snipe about who should be doing what is revolting; neither is doing anything real. The developed world funnels nearly $1 billion a day in subsidies to its own farmers, encouraging overproduction, which drives down commodity prices. Poor nations' farmers cannot compete with subsidized products, even within their own countries. In recent years, American farmers have been able to dump cotton, wheat, rice, corn and other products on world markets at prices that do not begin to cover their cost of production, all thanks to politicians and at the expense of American taxpayers. Europe's system, meanwhile, is even more odious: United States farm subsidies are equal to only a third of the European Union's.

"Odious" and "revolting" are not words lightly used by America's self-proclaimed newspaper of record. And they are right to use them. The one single thing that would have the greatest effect on world poverty is the simple abolition of our absurd system of agricultural subsidies. What is even more distressing to me is this:

But so far it has been nothing but talk, talk, talk on trade. While the rich continue their shameful obfuscating, poor countries are priced out of the market. A few weeks ago, the European Union's trade envoy, Peter Mandelson, actually complained to reporters that Europe had been making more than its fair share of compromises in the W.T.O. talks. "This process of compromise has been a one-way street for well over a year," he said.

We appear to have a Trade Commissioner who is two centuries behind the times. By compromise he means the shaving of a tariff here, the slight reduction of a subsidy there. But we've known ever since Ricardo that the precepts of mercantilism are incorrect. We should not be attempting to boost exports and limit imports, this is precisely and exactly the wrong way round. It is imports that make us rich, exports being merely the undesirable side of the bargain, that consumption which we must give up in order to get the imports which we desire more. These "negotiations" and "compromises" are all about what access the rest of the world might have to the EU market, yes, we'll allow you to sell your cheap and delicious produce to our citizens but only if you let our manufacturers sell your citizens their products. This leads to the almost Kafkaesque nightmare of the negotiations, where the offer is, well, if you keep your people poor by making manufactures more expensive then we'll keep ours poor by making food more expensive!

What is so absurd about the entire debate is that it is in our interest to abolish the Common Agricultural Policy. It consumes a fortune in tax and makes food across the continent grossly more expensive than it need be. We will be richer by doing away with it, so why is anyone negotiating on it at all? Get on with it!

By Paul Staines

07 January 2006

Mergers and Acquisitions

A corporate merger is the combination of the assets and liabilities of two firms to form a single business entity. In everyday language, the term acquisition tends to be used when a larger firm absorbs a smaller firm, and merger tends to be used when the combination is portrayed to be between equals. In a merger of firms that are approximate equals, there often is an exchange of stock in which one firm issues new shares to the shareholders of the other firm at a certain ratio. For the sake of this discussion, the firm whose shares continue to exist (possibly under a different company name) will be referred to as the acquiring firm and the firm whose shares are being replaced by the acquiring firm will be referred to as the target firm.

Excluding any synergies resulting from the merger, the total post-merger value of the two firms is equal to the pre-merger value. However, the post-merger value of each individual firm likely will be different from the pre-merger value because the exchange ratio of the shares probably will not exactly reflect the firms' values with respect to one another. The exchange ratio is skewed because the target firm's shareholders are paid a premium for their shares.

Synergy takes the form of revenue enhancement and cost savings. When two companies in the same industry merge, such as two banks, combined revenue tends to decline to the extent that the businesses overlap in the same market and some customers become alienated. For the merger to benefit shareholders, there should be cost saving opportunities to offset the revenue decline; the synergies resulting from the merger must be more than the initial lost value.

To calculate the minimum value of synergies required so that the acquiring firm's shareholders do not lose value, an equation can be written to set the post-merger share price equal to the pre-merger share price of the acquiring firm as follows:

Pre-merger Stock Price =

(pre-merger value of both firms + synergies) ----------------------------------------------
post-merger number of shares

The above equation then can be solved for the value of the minimum required synergies.

The success of a merger is measured by whether the value of the acquiring firm is enhanced by it. The practical aspects of mergers often prevent the forecasted benefits from being fully realized and the expected synergy may fall short of expectations.

04 January 2006

The business of knowledge in India

By Swati Lodh Kundu

BANGALORE - After success in business process outsourcing (BPO), India has begun to taste the fruits of knowledge process outsourcing (KPO). At present, the US alone accounts for 60% of the KPO work outsourced to low-cost locations like India, while UK and Canada account for 20%, the rest coming from Europe.

India has favorable government regulations that support R&D (research and development). The country is also adopting the intellectual property regime formulated by the World Trade Organization (WTO). The government offers financial incentives for R&D as well. Customs duties on clinical trial have been waived. Also, good clinical practice (GCP) guidelines have been made mandatory.

R&D investment in the country has seen 45% growth during 2002-04, at about US$6.8 billion, positioning India as the third most favorable destination for R&D investment, according to a recent study. In addition to 85% of the R&D carried out by the government through its research labs and PSUs (public sector units), several multinationals have set up R&D centers in India. The Council of Scientific & Industrial Research (CSIR), with 38 labs and 80 polytechnology transfer centers, has the largest R&D network in India. Apart from it, there are about 2,000 recognized R&D institutes. Every year 6,000 PhDs come out from the 380 universities in India. The country also has 2.5 million graduates. All these factors make it a favorable cost-effective location for research and development.

According to a report by Evalueserve, the Indian KPO market will grow about 49% by 2010. On the other hand, the BPO sector is slated to grow 30.6%. For clients, outsourcing knowledge-based work leads to significant cost savings. While an American MBA graduate earns $85,000 a year as a starting salary, his Indian counterpart earns only $12,000 - a cost savings of 85%. A PhD in the US earns $80,000 annually, while his Indian equivalent earns around $16,000.

Due to a 12-hour time difference between the US and India, a KPO vendor can provide a 24-hour work-cycle to the US client. According to the survey, 30% of the revenue of a typical KPO vendor is retained in the form of profits, while 35% goes to employee costs. The remaining 35% goes to overhead costs like transportation, food, telecom, security, etc.


KPO involves high-end processes like valuation research, investment research, patent filing, legal and insurance claims processing, online teaching and media content supply. In BPOs, there is a pre-defined way to solve a problem and employees are trained to learn that method. BPOs will normally include transaction processing, setting up a bank account, selling an insurance policy, technical support, voice and email-based support. In case of KPO, however, there is no pre-defined process. One can look at it as transformation of unsorted data into useful information.

India, with its firepower of chartered accountants, doctors, MBAs, lawyers and research analysts is well positioned to grab a big slice of the global KPO business. Those battling with India in this arena will be Russia, China, the Czech Republic, Ireland and Israel. China is likely to get a bigger share of the Japanese and Korean markets due to cultural similarities. Russia, with its third-largest army of engineers and doctors in the world, will make a bid to capture the European KPO market. Close proximity and cultural compatibility will boost its position as an attractive nearshoring country for European businesses. But Cold War inertia and isolation from the US in the past will hamper its overall growth as a viable KPO base. It will also face competition from Ireland and the Czech Republic in the European market.

India, with its knowledge base and lower costs, will be leading the pack in the race for KPO businesses. According to the Evalueserve report, India will capture more than 70% (approximately $12 billion) of the KPO territory by 2010. The most sought after will be professionals well versed in data search and management. Biotech and pharma graduates will be in demand. While data search will constitute 29%, pharma and R&D will form 18% of the $17-billion global KPO pie. Other hot areas will be animation, publishing, remote education, VLSI (Very Large Scale Integrated) chip and engineering design.

With more and more KPO business coming into India, BPOs will try to upgrade themselves into KPO units as revenue per unit is more in the latter than former. And the first to benefit will be those already working in a BPO, with some degree of specialization. According to Evalueserve estimates, "Drafting and filing of a patent application costs anywhere between $10,000 and $15,000 [in the West]. Offshoring even a small portion of the process to an agent in India can save up to 50% for the end-client." India is already a hub for those willing to outsource their R&D operations, be it chip design or pharma and biotech research. In fact, quite a few companies are locating their R&D divisions in India. Some US law firms have set up their captive centers in India. Others are collaborating with Indian firms for the same.

Also, being high up in the value chain, KPOs offer considerably higher incentives to rope in talent. The Evalueserve report reveals that whereas an Indian BPO executive earns about $6,000 a year, his KPO cousin is sure to make anywhere above $8,800 - a huge 46% difference. The salary gap is not limited to BPO versus KPO. Whereas a fresh medical graduate or lawyer earns Rs150,000 (US$3,400) annually, a job with KPO offers at least 500% more. Fresh doctors and lawyers take home a cool Rs600,000-800,000 salary package at KPOs. Compare this with the pay packets of MBAs from non-IIM (Indian Institute of Management) institutes, who take home Rs300,000-500,000 per annum, or the yearly package for fresh IIM grads, at Rs400,000-600,000. Economists and statisticians are also in great demand for data modeling and analysis.

In contrast to BPOs, KPOs require understanding of how a client works. But the contracts in the KPO industry will be of much shorter duration. They may range anywhere from three weeks to six months. So delivering high-quality work will be a major challenge. Several Indian BPOs have recognized this opportunity and are in the process of developing KPO capability.

Over the last couple of years, small Indian KPOs have emerged and are doing well. However, it's MNCs like GE and Evalueserve, with their huge resources, which have been doing better. GE has been hugely successful with its 2,000-strong workforce at its research center in Bangalore. Efunds has more than 80% of its workforce in India. The figure for Evalueserve is even more astonishing - Out of 650 employees globally, 600 are based in India.

Clearly, in the future, it's KPO rather than BPO that will put India in the cutting edge of outsourcing business. Moreover, with countries like Ukraine, Hungary, Belgium, the Czech Republic and the Philippines offering BPO services at a lower rate, India will have to tilt toward KPO more heavily at some point. India, it is estimated, will have more than 250,000 KPO professionals by 2010. At present, the figure stands at a mere 25,000.

However, KPO will not crowd out the BPO business altogether. Revenues in absolute terms will always be higher from BPOs. While KPO exports from India are projected at $12 billion by 2010, BPO exports will be much higher at $20 billion for the same year. But India may start to lose its low-cost advantage in the future, as low-end services may move to cheaper destinations like Ukraine, Belarus and Malaysia. Developing its KPO industry is thus an absolute necessity for India to stay ahead in the global outsourcing game.

02 January 2006

Doing business in a cultural minefield

BRISBANE - Despite globalization, cross-cultural differences remain a potential minefield for any company wanting to do business overseas. While in the West the deal is the thing, in the East the onus is on building relationships.

Even among countries with cultural ties to Australia, different ways of doing business remain because of contrasting etiquette, manners and communication traditions. Queensland University of Technology business lecturer Cheryl Rivers says every culture is different and learning the subtlety of these differences can smooth the way forward for business. If not, anger and accusations of deception can sour a budding relationship.

In her studies funded by ENS International, Dr Rivers said research showed 30% of international negotiators believed they were deceived by the other party. She said when an offer of money is considered a token of friendship in one culture and a bribe in another, there is no wonder cross-cultural negotiations break down. "When business negotiators negotiate overseas and the other party does something they think is unethical, it makes them really, really mad," Dr Rivers said. "It makes us mad even if we are both Australian but if it is across cultures it makes us madder, it is almost like it exacerbates the problem."

Dr Rivers, who recently presented her paper, said Australians are generally regarded as being more mindful of other cultures. "Asian business perceives us as being culturally sensitive and that's quite true in comparison to some of the other Western cultures that almost insist on 'doing it our way'. However I still think there is a problem that many businesses simply don't know how people from another culture behave. There remain many companies who fail to train staff in the cultural differences of the country they're dealing with."

She said: "I've spoken to people from leading companies in Australia who have been sent to a country like China to start up a new office and who have had no cultural training at all." A typical cultural difference between Australia and China is the concept of guanxi, which is based on obligations or relationships with others to achieve outcomes. "Australians have a very strong separation between business and friendship, which is a complete contradiction for the Chinese," Dr Rivers said. "Australians are angered by gift money, which they take as bribery. But really it's gift money and they're trying to strengthen the relationship."

In Eastern countries, there are also long-held concepts of collectivism, saving face and status, which are markedly different from the West's individualism and blunt, analytical approach. But Dr Rivers said there are differences within Western countries as well. American negotiators usually turn up as a team at the start of negotiations, while Australians tend to bring in lawyers and others at the end of the process. "If you're going to negotiate in America and go over as the sole rep of your company, find some fellow Aussies, put them in suits and go in as a team," she said. "Americans seem to have more of a sense of hierarchy than us."

But Dr Rivers said a culturally sensitive person can always wriggle out of tight situations. She said a businesswoman she knows with a non-gender-specific first name had been negotiating with a Japanese firm for months by fax and email. "A Japanese buyer was coming out and she went to the airport to meet him. He was an old Japanese gentleman and in the older generation in Japan, they tend not to be comfortable dealing with women," Dr Rivers said.

"Anyway, she saw him and went up to him and bowed because she was culturally aware and said who she was and the gentleman went ashen faced because he had been dealing with a woman. She noticed this and bowed deeper and introduced her husband who, she said, runs the company and she then backed off. But he doesn't run the company, had nothing to do with it. She recognized there was this impenetrable cultural barrier. Apparently in the end her husband did quite a good job," according to Dr Rivers.

01 January 2006

Terminal Value

In a discounted cash flow valuation, the cash flow is projected for each year into the future for a certain number of years, after which unique annual cash flows cannot be forecasted with reasonable accuracy. At that point, rather than attempting to forecast the varying cash flow for each individual year, one uses a single value representing the discounted value of all subsequent cash flows. This single value is referred to as the terminal value.

The terminal value can represent a large portion of the valuation. The terminal value of a piece of manufacturing equipment at the end of its useful life is its salvage value, typically less than 10% of the present value. In contrast, the terminal value associated with a business often is more than 50% of the total present value. For this reason, the terminal value calculation often is critical in performing a valuation. The terminal value can be calculated either based on the value if liquidated or based on the value of the firm as an ongoing concern.

Terminal Value if Liquidated

If the firm is to be liquidated, the liquidation value can be based on book value, salvage value, or break-up value, but liquidation value usually understates the terminal value of a healthy business. One must make assumptions about the salvage value of the assets and net working capital. The net working capital may have a certain recovery rate since it might not be readily liquidated at balance sheet values. In the pro forma projections, one often may assume that net working capital will grow at the same rate as cash flow. The terminal value if the firm is liquidated then is the sum of the discounted value of the cash flow, the recovered net working capital, and the salvage value of the long-term assets, including any tax benefits.

Terminal Value of the Ongoing Firm

For an ongoing firm, the terminal value may be determined by either using discounted cash flow (DCF) estimates or by using multiples from comparable firms.

For the DCF method, if the unlevered free cash flow is growing at a rate of g per year for a set number of years, the terminal value can be calculated by modeling the cash flow as a T-year growing perpetuity. At the end of T years, one can assume a different growth rate (possibly zero) or liquidation. If multiples from comparable firms are used, the price/earnings ratio, market/book values, or cash flow multiples are commonly used.

The unlevered terminal value is calculated using the return on assets (rA) as the discount rate. The levered terminal value is calculated using the weighted average cost of capital (WACC) as the discount rate.

Terminal Value of the Debt

The terminal value of debt or preferred stock is simply the projected book value of the debt or preferred stock in the year that the terminal value is being calculated.

Terminal Value of the Common Stock

The terminal value of the common stock is the total levered terminal value less the terminal value of the debt, less the terminal value of the preferred stock (adding in the amount from any warrants that are exercised at their exercise price), plus the cash gained from the exercise of any common and preferred warrants.