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Market-Based Solutions to Vital Economic Issues
Research
Feb 26, 2018

Financial Flexibility and Opportunity Capture: Bridging the Gap Between Finance and Strategy

Abstract

Although both businessmen and scholars agree that the practice of corporate finance and corporate strategy should be closely coordinated and logically consistent, a large gap exists between the two functions. Although MBA programs routinely cover both subjects, they employ very different analytical and decision tools and the interaction between the two bodies of knowledge rarely receives the attention it deserves. The resulting Finance-Strategy gap can lead strategically oriented firms to de-emphasize or even discard classic finance techniques such as Net Present Value (NPV).

Conceptual limitations exist on both sides of the Finance-Strategy gap. For example, textbook theory usually emphasizes investment decisions based on the NPV framework with its longstanding grounding in marginal economic analysis and implicit assumption that firms can raise capital in frictionless financial markets. It is well known that the NPV framework does not address the information and incentive problems that often bedevil capital allocation within firms; and it is not applicable in its usual form in the presence of growth, market disruptions, or real options. Moreover, the NPV framework is typically implemented through cash flow forecasting that emphasizes short to medium time horizons ill-suited for strategy formulation. Perhaps most important, advanced corporate finance courses that consider capital structure policy typically focus on minimizing the firm’s weighted average cost of capital through tax optimization. This ignores the crucial role of financial flexibility in developing and sustaining competitive advantage. Meanwhile, on the other side of the gap strategy textbooks and cases barely mention finance, consigning it to a utility-like enabler role. In doing so, they neglect its potential as a competitive advantage weapon.

Thus, when newly minted MBAs embark on managerial careers, they often find financial concepts such as the Cost of Capital and Capital Structure surprisingly difficult to deploy in the service of strategy. Upon reaching senior decision-making levels, they find that strategy formulation often proceeds without the discipline financial theory brings to project selection. While some may realize that husbanded financial flexibility can be value creating in its own right, very few know how to incorporate that value in formal analysis. Consequently, in most firms both the practice of finance and of strategy suffers as those functions operate in silos and enterprises underperform. When good managers do learn how to develop closer connections between Finance and Strategy it is by trial and error.

The following case study based on Exxon-Mobil’s experience illustrates these serious management problems. This case will help develop a conceptual framework that integrates finance and strategy to provide better guidance than trial and error.


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