Myers Strategy and Finance

Finance Theory and Financial Strategy

STEWART C . MYERS Sloan School of ManagementMassachusetts Institute of TechnologyCambridge, Massachusetts 02139

Despite its major advances, finance theory has had scant im-pact on strategic planning. Strategic planning needs financeand should learn to apply finance theory correctly. Hov^ever,finance theory must be extended in order to reconcile financialand strategic analysis.

S trategic planning is many things, but (1) Finance theory and traditional ap-it surely includes the process of de- proaches to strategic planning may betrategic planning is many things, butit surely includes the process of de-

ciding how to commit the firm's resourcesacross lines of business. The financial sideof strategic planning allocates a particularresource, capital.

Finance theory has made major ad-vances in understanding how capitalmarkets work and how risky real and fi-nancial assets are valued. Tools derivedfrom finance theory, particularly dis-counted cash-flow analysis, are widelyused. Yet finance theory has had scantimpact on strategic planning.

I attempt here to explain the gapbetween finance theory and strategicplanning. Three explanations are offered:

kept apart by differences in languageand "culture."

(2) Discounted cash flow analysis mayhave been misused, and consequentlynot accepted, in strategic applications.

(3) Discounted cash flow analysis may failin strategic applications even if it isproperly applied.

Each of these explanations is partly true. Ido not claim that the three, taken to-gether, add up to the whole truth. Never-theless, I will describe both the problemsencountered in applying finance theory tostrategic planning, and the potentialpayoffs if the theory can be extended and

Copyright © 1984, The Institute of Management Sdences0092-2102/84/140i;0126$01.25

PLANNING — CORPORATEFINANCE — CORPORATE FINANCE

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properly applied.The first task is to explain what is

meant by "finance theory" and the gapbetween it and strategic planning.The Relevant Theory

The financial concepts most relevant tostrategic planning are those dealing withfirms' capital investment decisions, andthey are sketched here at the minimumlevel of detail necessary to define "financetheory."

Think of each investment project as amini-firm, all-equity financed. Supposeits stock could be actively traded. If weknow what the mini-firm's stock wouldsell for, we know its present value, andtherefore the project's present value. Wecalculate net present value (NPV) by sub-tracting the required investment.

In other words, we calculate each proj-ect's present value to investors who havefree access to capital markets. We shouldtherefore use the valuation model whichbest explains the prices of similar securi-ties. However, the theory is usually boileddown to a single model, discounted cashfiow (DCF):

where PV = present (market) value;Ct = forecasted incremental cash flow

after corporate taxes — strictlyspeaking the mean of the distribu-tion of possible C/s;

T = project life (Cr includes any sal-vage value);

r = the opportunity cost of capital,defined as the equilibrium ex-pected rate of return on securities

equivalent in risk to the projectbeing valued.

equals PV less the cash outlay re-quired at t = 0.

Since present values add, the value ofthe firm should equal the sum of the val-ues of all its mini-firms. If the DCF for-mula works for each project separately, itshould work for any collection of projects,a line of business, or the firm as a whole.A firm or line of business consists of in-tangible as well as tangible assets, andgrowth opportunifies as well as assets-in-place. Intangible assets and growthopportunities are clearly refiected in stockprices, and in principle can also be valuedin capital budgeting. Projects bringing in-tangible assets or growth opportunities tothe firm have correspondingly higherNPVs. I will discuss whether DCF for-mulas can capture this extra value later.

The opportunity cost of capital variesfrom project to project, depending onrisk. In principle, each project has its owncost of capital. In practice, firms simplifyby grouping similar projects in riskclasses, and use the same cost of capitalfor all projects in a class.

The opportunity cost of capital for a lineof business, or for the firm, is a value-weighted average of the opportunity costsof capital for the projects it comprises.

The opportunity cost of capital dependson the use of funds, not on the source. Inmost cases, financing has a second-orderimpact on value: You can make muchmore money through smart investmentdecisions than smart financing decisions.The advantage, if any, of departing fromall-equity financing is typically adjustedfor through a somewhat lowered discount

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rate.Finance theory stresses cash fiow and

the expected return on compefing assets.The firm's investment opportunities com-pete with securifies stockholders can buy.Investors willingly invest, or reinvest,cash in the firm only if it can do better,risk considered, than the investors can doon their own.

Finance theory thus stresses fundamen-tals. It should not be deflected by account-ing allocations, except as they affect cashtaxes. For example, suppose a positive-NPV project sharply reduces book earn-ings in its early stages. Finance theorywould recommend forging ahead, trust-ing investors to see through the account-ing bias to the project's true value. Empir-ical evidence indicates that investors dosee through accounting biases; they donot just look naively at last quarter's orlast year's EPS. (If they did, all stockswould sell at the same price-earningsratio.)

All these concepts are generally ac-cepted by financial economists. The con-cepts are broadly consistent with an up-to-date understanding of how capitalmarkets work. Moreover, they seem to beaccepted by firms, at least in part: anytime a firm sets a hurdle rate based oncapital market evidence, and uses a DCFformula, it must implicitly rely on thelogic I have sketched. So the issue here isnot whether managers accept financetheory for capital budgeting (and for otherfinancial purposes). It is why they do notuse the theory in strategic planning.The Gap Between Finance Theory andStrategic Planning

I have resisted referring to strategic

planning as "capital budgefing on a grandscale," because capital budgeting in prac-tice is a bottom-up process. The aim is tofind and undertake specific assets or proj-ects that are worth more than they cost.

Picking valuable pieces does not insuremaximum value for the whole. Piecemeal,bottom-up capital budgeting is notstrategic planning.

Capital budgeting techniques, however,ought to work for the whole as well as theparts. A strategic commitment of capitalto a line of business is an investmentproject. If management does invest, theymust believe the value of the firm in-creases by more than the amount of capi-tal committed — otherwise they arethrowing money away. In other words,there is an implicit estimate of net presentvalue.

This would seem to invite the applica-tion of finance theory, which explainshow real and financial assets are valued.The theory should have direct applicationnot only to capital budgeting, but also tothe financial side of strategic planning.

Of course it has been applied to someextent. Moreover, strategic planningseems to be becoming more financiallysophisticated. Financial concepts arestressed in several recent books on corpo-rate strategy [Fruhan 1979; Salter andWeinhold 1979; and Beirman 1980]. Con-sulting firms have developed the con-cepts' strategic implications [Alberts1983].

Nevertheless, I believe it is fair to saythat most strategic planners are notguided by the tools of modem finance.Strategic and financial analyses are notreconciled, even when the analyses are of

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the same major project. When low netpresent value projects are nurtured "forstrategic reasons," the strategic analysisoverrides measures of financial value.Conversely, projects with apparently highnet present values are passed by if theydon't fit in with the firm's strategic objec-tives. When financial and strategicanalyses give conflicting answers, theconflict is treated as a fact of life, not as ananomaly demanding reconciliation.

In many firms, strategic analysis ispartly or largely directed to variables fi-nance theory says are irrelevant. This isanother symptom of the gap, for example:(1) Many managers worry about a

strategic decision's impact on bookrate of return or earnings per share. Ifthey are convinced the plan adds tothe firm's value, its impact on account-ing figures should be irrelevant.

(2) Some managers pursue diversificationto reduce risk — risk as they see it.Investors see a firm's risk differently.In capital markets, diversification ischeap and easy. Investors who wantto diversify do so on their own. Cor-porate diversification is redundant;the market will not pay extra for it.

If the market were willing to pay extrafor diversification, closed-end fundswould sell at premiums over net assetvalue, and conglomerate firms would beworth more to investors than their com-ponents separately traded. Closed-endfunds actually sell at discounts, not pre-miums. Conglomerates appear to sell atdiscounts too, although it is hard to proveit, since the firm's components are nottraded separately.

Much of the literature of strategic plan-

ning seems extremely naive from a finan-cial point of view. Sometimes capital mar-kets are ignored. Sometimes firms are es-sentially viewed as having a fixed stock ofcapital, so that "cash cows" are needed tofinance investment in rapidly growinglines of business. (The firms thatpioneered in strategic planning actuallyhad easy access to capital markets, as doalmost all public companies.) Firms maynot like the price they pay for capital, butthat price is the opportunity cost of capi-tal, the proper standard for new invest-ment by the firm.

The practical conflicts between financeand strategy are part of what lies behindthe recent criticism of US firms for al-legedly concentrating on quick payoffs atthe expense of value. US executives,especially MBAs, are said to rely toomuch on purely financial analysis, andtoo little on building technology, prod-ucts, markets, and production efficiency.The financial world is not the real world,the argument goes; managers succumb tothe glamour of high finance. They givetime and talent to mergers, spinoffs, un-usual securifies, and complex financingpackages when they should be out on thefactory fioor. They pump up current earn-ings per share at the expense of long-runvalues.

Much of this cridcism is not directedagainst finance theory, but at habits of fi-nancial analysis that financial economistsare attempting to reform. Finance theoryof course concentrates on the financialworld — that is, capital markets. How-ever, it fundamentally disagrees with theimplicit assumption of the critics, who saythat the financial world is not the real


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world, and that financial analysis divertsattention from, and sometimes activelyundermines, real long-run values. Theprofessors and textbooks actually say thatfinancial values rest on real values andthat most value is created on the left-handside of the balance sheet, not on the right.

Finance theory, however, is under at-tack too. Some feel that any quantitativeapproach is inevitably short-sighted.Hayes and Garvin, for example, haveblamed discounted cash flow for a sig-nificant part of this country's industrialdifficulties. Much of their criticism seemsdirected to misapplications of discountedcash flow, some of which I discuss later.But they also believe the underlyingtheory is wanting; they say that "beyondall else, capital investment represents anact of faith" [Hayes and Garvin 1982, p.79]. This statement offends most card-carrying financial economists.

I do not know whether "gap" fully de-scribes all of the problems noted, orhinted at, in the discussion so far. Insome quarters, finance theory is effec-tively ignored in strategic planning. Inothers, it is seen as being in conflict, orworking at cross-purposes, with otherforms of strategic analysis. The problem isto explain why.Two Cultures and One Problem

Finance theory and strategic planningcould be viewed as two cultures lookingat the same problem. Perhaps only differ-ences in language and approach make thetwo appear incompatible. If so, the gapbetween them might be bridged by bettercommunication and a determined effort toreconcile them.

Think of what can go wrong with

standard discounted cash flow analyses ofa series of major projects:(1) Even careful analyses are subject to

random error. There is a 50 percentprobability of a positive NPV for atruly border-line project.

(2) Firms have to guard against these er-rors dominating project choice.

(3) Smart managers apply the followingcheck. They know that all projectshave zero NPV in long-run competi-tive equilibrium. Therefore, a positiveNPV must be explained by a short-rundeviation from equilibrium or by somepermanent competitive advantage. Ifneither explanation applies, the posi-tive NPV is suspect. Conversely, anegative NPV is suspect if a competi-tive advantage or short-run deviationfrom equilibrium favors the project.

In other words, smart managers do notaccept positive (or negative) NPVs unlessthey can explain them.

Strategic planning may serve to imple-ment this check. Strategic analyses lookfor market opportunities — deviationsfrom equilibrium — and try to identify thefirms' competitive advantages.

Turn the logic of the example around.We can regard strategic analysis whichdoes not explicitly compute NPVs asshowing absolute faith in Adam Smith'sinvisible hand. If a firm, looking at a lineof business, finds a favorable deviationfrom long-run equilibrium, or if it iden-tifies a competitive advantage, then (effi-cient) investment in that line must offerprofits exceeding the opportunity cost ofcapital. No need to calculate the invest-ment's NPV: the manager knows in ad-vance that NPV is positive.

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The trouble is that strategic analyses arealso subject to random error. Mistakes arealso made in identifying areas of competi-tive advantage or out-of-equilibrium mar-kets. We would expect strategic analyststo calculate NPVs explicitly, at least as acheck; strategic analysis and financialanalysis ought to be explicitly reconciled.Few firms attempt this. This suggests thegap between strategic planning and fi-nance theory is more than just "two cul-tures and one problem."

The next step is to ask why reconcilia-tion is so difficult.Misuse of Finance Theory

The gap between strategic and financialanalysis may reflect misapplication of fi-nance theory. Some firms do not try touse theory to analyze strategic invest-ments. Some firms try but make mistakes.

I have already noted that in many firmscapital investment analysis is partly orlargely directed to variables finance theorysays are irrelevant. Managers worry aboutprojects' book rates of return or impactson book earnings per share. They worryabout payback, even for projects thatclearly have positive NPVs. They try toreduce risk through diversification.

Departing from theoretically-correctvaluation procedures often sacrifices thelong-run health of the firm for the short,and makes capital investment choices ar-bitrary or unpredictable. Over time, thesesacrifices appear as disappointing growth,eroding market share, loss of technologi-cal leadership, and so forth.

The non-financial approach taken inmany strategic analyses may be an at-tempt to overcome the short horizons andarbitrariness of financial analysis as it is

often misapplied. It may be an attempt toget back to fundamentals. Remember,however: finance theory never left thefundamentals. Discounted cash flowshould not in principle bias the firmagainst long-lived projects, or be swayedby arbitrary allocations.

However, the typical mistakes made inapplying DCF do create a bias againstlong-lived projects. I will note a fewcommon mistakes.Ranking on Internal Rate of Return

Competing projects are often ranked oninternal rate of return rather than NPV. Itis easier to earn a high rate of return ifproject life is short and investment issmall. Long-lived, capital-intensive proj-ects tend to be put down the list even iftheir net present value is substantial.

The internal rate of return does meas-ure bang per buck on a DCF basis. Firmsmay favor it because they think they haveonly a limited number of bucks. However,most firms big enough to do formalstrategic planning have free access to capi-tal markets. They may not like the price,but they can get the money. The limits oncapital expenditures are more often set in-side the firm, in order to control an or-ganization too eager to spend money.Even when a firm does have a strictly lim-ited pool of capital, it should not use theinternal rate of return to rank projects. Itshould use NPV per dollar invested, orlinear programming techniques when cap-ital is rationed in more than one period[Brealey and Myers 1981, pp. 101-107].Inconsistent Treatment of Inflation

A surprising number of firms treat infla-tion inconsistently in DCF calculations.High nominal discount rates are used but


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cash flows are not fully adjusted for fu-ture inflation. Thus accelerating inflationmakes projects — especially long-livedones — look less attractive even if theirreal value is unaffected.Unrealistically High Rates

Some firms use unrealistically high dis-count rates, even after proper adjustmentfor inflation. This may reflect ignorance ofwhat normal returns in capital marketsreally are. In addition:(1) Premiums are tacked on for risks that

can easily be diversified away instockholders' portfolios.

(2) Rates are raised to offset the optimisticbiases of managers sponsoring proj-ects. This adjustment works only ifthe bias increases geometrically withthe forecast period. If it does not,long-lived projects are penalized.

(3) Some projects are unusually risky atinception, but only of normal-riskonce the start-up is successfullypassed. It is easy to classify this typeof project as "high-risk," and to add astart-up risk premium to the discountrate for all future cash flows. The riskpremium should be applied to thestartup period only. If it is appliedafter the startup period, safe, short-lived projects are artifically favored.

Discounted cash flow analysis is alsosubject to a difficult organizational prob-lem. Capital budgeting is usually abottom-up process. Proposals originate inthe organization's midriff, and have tosurvive the trip to the top, getting ap-proval at every stage. In the process polit-ical alliances form, and cash flow forecastsare bent to meet known standards. An-swers — not necessarily the right ones —

are worked out for anticipated challenges.Most projects that get to the top seem tomeet profitability standards set by man-agement.

According to Brealey and Myers's Sec-ond Law, "The proportion of proposedprojects having positive NPV is indepen-dent of top management's estimate of theopportunity cost of capital" [Brealey andMyers 1981, p. 238].

Suppose the errors and biases of thecapital budgeting process make it ex-tremely difficult for top management toverify the true cash flows, risks and pre-sent value of capital investment propo-sals. That would explain why firms do nottry to reconcile the results of capitalbudgeting and strategic analyses. How-ever, it does not explain why strategicplanners do not calculate their ownNPVs.

We must ask whether those in topmanagement — the managers who makestrategic decisions — understand financetheory well enough to use DCF analysiseffectively. Although they certainlyunderstand the arithmetic of the calcula-tion, they may not understand the logic ofthe method deeply enough to trust it or touse it without mistakes.

They may also not be familiar enoughwith how capital markets work to use cap-ital market data effectively. The wide-spread use of unrealistically high discountrates is probably a symptom of this.

Finally, many managers distrust thestock market. Its volatility makes themnervous, despite the fact that the volatilityis the natural result of a rational market. Itmay be easier to underestimate thesophistication of the stock market than to

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accept its verdict on how well the firm isdoing.Finance Theoiy May Have Missed the Boat

Now consider a firm that understandsfinance theory, applies DCF analysis cor-rectly, and has overcome the human andorganizational problems that bias cashflows and discount rates. Carefully esti-mated net present values for strategic in-vestments should help significantly.However, would they fully grasp and de-scribe the firm's strategic choices? Perhapsnot.

There are gaps in finance theory as it isusually applied. These gaps are notnecessarily intrinsic to finance theorygenerally. They may be filled by new ap-proaches to valuation. However, if theyare the firm will have to use somethingmore than a straightforward discountedcash flow method.

An intelligent application of discountedcash flow will encounter four chief problems:(1) Estimating the discount rate,(2) Estimating the project's future cash flows,(3) Estimating the project's impact on the

firm's other assets' cash flows, that isthrough the cross-sectional links be-tween projects, and

(4) Estimating the project's impact on thefirm's future investment oppor-tunities. These are the time serieslinks between projects.

The first three problems, difficult asthey are, are not as serious for financialstrategy as the fourth. However, I will re-view all four.Estimating the Opportunity Cost of Capital

The opportunity cost of capital will al-ways be difficult to measure, since it is anexpected rate of return. We cannot com-

mission the Gallup Poll to extract proba-bUity distributions from the minds of in-vestors. However, we have extensive evi-dence on past average rates of return incapital markets [Ibbotsen and Sinquefield1982] and the corporate sector [Hollandand Myers 1979]. No long-run trends in"normal" rates of return are evident. Rea-sonable, ballpark cost of capital estimatescan be obtained if obvious traps (forexample, improper adjustments for risk orinflation) are avoided. In my opiruon, es-timating cash flows properly is more im-portant than fine-tuning the discount rate.Forecasting Cash Flow

If s impossible to forecast most projects'actual cash flows accurately. DCF calcula-tions do not call for accurate forecasts,however, but for accurate assessments ofthe mean of possible outcomes.

Operating managers can often makereasonable subjective forecasts of theoperating variables they are responsiblefor — operating costs, market growth,market share, and so forth — at least forthe future that they are actually worryingabout. It is difficult for them to translatethis knowledge into a cash flow forecastfor, say, year seven. There are severalreasons for this difficulty. First, theoperating manager is asked to look into afar future he is not used to thinking ab-out. Second, he is asked to express hisforecast in accounting rather than operat-ing variables. Third, incorporating fore-casts of macroeconomic variables is dif-ficult. As a result, long-rim forecasts oftenend up as mechanical extrapolations ofshort-run trends. It is easy to overlook thelong-run pressures of competition, infla-tion, and technical change.


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It should be possible to provide a betterframework for forecasting operating var-iables and translating them into cashflows and present value — a frameworkthat makes it easier for the operatingmanager to apply his practical knowledge,and that explicitly incorporates informa-tion about macroeconomic trends. Thereis, however, no way around it: forecastingis intrinsically difficult, especially whenyour boss is watching you do it.Estimating Cross-Sectional RelationshipsBetween Cash Flows

Tracing "cross-sectional" relationshipsbetween project cash flows is also intrinsi-cally difficult. The problem may be mademore difficult by inappropriate project de-finitions or boundaries for Unes of busi-nesses. Defining business units properlyis one of the tricks of successful strategicplanning.

However, these inescapable problemsin estimating profitability standards, fu-ture cash returns, and cross-sectional in-teractions are faced by strategic plannerseven if they use no financial theory. Theydo not reveal a flaw in existing theory.Any theory or approach encounters them.Therefore, they do not explain the gap be-tween finance theory and strategic plan-ning.The Links Between Today's Investmentsand Tomorrow's Opportunities

The fourth problem — the link betweentoday's investments and tomorrow's op-portunities — is much more difficult.

Suppose a firm invests in a negative-NPV project in order to establish a foot-hold in an attractive market. Thus a valu-able second-stage investment is used tojustify the immediate project. The

second-stage must depend on the first: ifthe firm could take the second projectwithout having taken the first, then thefuture opportunity should have no impacton the immediate decision. However, iftomorrow's opportunities depend on to-day's decisions, there is a time-series linkbetween projects.

At first glance, this may appear to bejust another forecasting problem. Whynot estimate cash flows for both stages,and use discounted cash flow to calculatethe NPV for the two stages taken to-gether?

You would not get the right answer.The second stage is an option, and con-ventional discounted cash flow does notvalue options properly. The second stageis an option because the firm is not com-mitted to undertake it. It will go ahead ifthe first stage works and the market is stillattractive. If the first stage fails, or if themarket sours, the firm can stop afterStage 1 and cut its losses. Investing inStage 1 purchases an intangible asset: acall option on Stage 2. If the option's pre-sent value offsets the first stage's negativeNPV, the first stage is justified.The Limits of Discounted Cash Flow

The limits of DCF need further explana-tion. Think flrst of its application to fourtypes of securities:(1) DCF is standard for valuing bonds,

preferred stocks and other fixed-income secvirities.

(2) DCF is sensible, and widely used, forvaluing relatively safe stocks payingregular dividends.

(3) DCF is not as helpful in valuing com-panies with signiflcant growth oppor-tunities. The DCF model can be

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stretched to say that Apple Com-puter's stock price equals the presentvalue of the dividends the firm mayeventually pay. It is more helpful tothink of Apple's price, Po, as:

Pn = = PVGO,

whereEPS = normalized current earnings

r = the opportimity cost of capitalPVGO = the net present value of future

growth opportunities.Note that PVGO is the present valueof a portfolio of options — the firm'soptions to invest in second-stage,third-stage, or even later projects.

(4) DCF is never used for traded calls orputs. Finance theory supplies optionvaluation formulas that work, but theoption formulas look nothing likeDCF.

Think of the corporate analogs to thesesecurities:(1) There are few problems in using DCF

to value safe flows, for example, flowsfrom financial leases.

(2) DCF is readily applied to "cash cows"— relatively safe businesses held forthe cash they generate, rather than forstrategic value. It also works for "en-gineering investments," such asmachine replacements, where themain benefit is reduced cost in aclearly-defined activity.

(3) DCF is less helpful in valuing busi-nesses with substantial growth oppor-tunities or intangible assets. In otherwords, it is not the whole answerwhen options account for a large frac-tion of a business' value.

(4) DCF is no help at all for pure researchand development. The value of R&Dis almost all option value. Intangibleassets' value is usually option value.

The theory of option valuation has beenworked out in detail for securities — notonly puts and calls, but warrants, conver-tibles, bond call options, and so forth. Thesolution techniques should be applicableto the real options held by firms. Severalpreliminary applications have alreadybeen worked out, for example:

(1) Calculations of the value of a Federallease for offshore exploration for oil orgas. Here the option value comes fromthe lessee's right to delay the deci-sions to drill and develop, and tomake these decisions after observingthe extent of reserves and the futurelevel of oil prices [Paddock, Siegel,and Smith 1982].

(2) Calculating an asset's abandonment orsalvage value: an active second-handmarket increases an asset's value,other things equal. The second-handmarket gives the asset owner a put op-tion which increases the value of theoption to bail out of a poorly perform-ing project [Myers and Majd 1983].

The option "contract" in each of thesecases is fairly clear: a series of calls in thefirst case and a put in the second. How-ever, these real options last longer and aremore complex than traded calls and puts.The terms of real options have to be ex-tracted from the economics of the problemat hand. Realistic descriptions usuallylead to a complex implied "contract," re-quiring numerical methods for valuation.

Nevertheless, option pricing methodshold great promise for strategic analysis.


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The time-series links between projects arethe most important part of financialstrategy. A mixture of DCF and optionvaluation models can, in principle, de-scribe these links and give a better under-standing of how they work. It may also bepossible to esfimate the value of particularstrategic options, thus eliminating onereason for the gap between finance theoryand strategic planning.Lessons for Corporate Strategy

The task of strategic analysis is morethan laying out a plan or plans. Whentime-series links between projects are im-portant, it's better to think of strategy asmanaging the firm's portfolio of real op-tions [Kestler 1982]. The process of finan-cial planning mdy be thought of as:(1) Acquiring options, either by investing

directly in R&D, product design, costor quality improvements, and soforth, or as a by-product of direct capi-tal investment (for example, inveshngin a Stage 1 project with negative NPVin order to open the door for Stage 2).

(2) Abandoning options that are too far"out of the money" to pay to keep.

(3) Exercising valuable options at theright time — that is, buying the cashproducing as sets that ultimately pro-duce positive net present value.

There is also a lesson for current appli-cations of finance theory to strategic is-sues. Several new approaches to financialstrategy use a simple, traditional DCFmodel of the firm, [For example, Fruhan1979, Ch. 2]. These approaches are likelyto be more useful for cash cows than forgrowth businesses with substantial riskand intangible assets.

The option value of growth and intan-

gibles is not ignored by good managerseven when conventional financial tech-niques miss them. These values may bebrought in as "strategic factors," dressedin non-financial clothes. Dealing with thefime series links between capital invest-ments, and with the opfion value theselinks create, is often left to strategic plan-ners. But new developments in financetheory promise to help.Bridging the Gap

We can summarize by asking how thepresent gap between finance theory andstrategic planning might be bridged.

Strategic planning needs finance. Pre-sent value calculafions are needed as acheck on strategic analysis and vice versa.However, the standard discounted cashfiow techniques will tend to understatethe option value attached to growing, pro-fitable lines of business. Corporate financetheory requires extension to deal with realoptions. Therefore, to bridge the gap weon the financial side need to:

(1) Apply exisfing finance theory cor-rectly.

(2) Extend the theory. I believe the mostpromising line of research is to try touse option pricing theory to model thefime-series interactions between in-vestments.

Both sides could make a conscious ef-fort to reconcile financial and strategicanalysis. Although complete reconcilia-tion will rarely be possible, the attemptshould uncover hidden assumptions andbring a generally deeper understanding ofstrategic choices. The gap may remain,but with better analysis on either sideof it.

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Paddock, J. L.; Siegel, D.; and Smith, J. L.1983, "Option valuation of claims on physicalassets: the case of offshore petroleumleases," Working Paper, MIT Energy Labora-tory, Cambridge, Massachusetts.

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