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Finance Theory and Financial StrategyAuthor(s): Stewart C. MyersSource: Interfaces, Vol. 14, No. 1, Strategic Management (Jan. - Feb., 1984), pp. 126-137Published by: INFORMSStable URL: http://www.jstor.org/stable/25060526Accessed: 04/07/2010 07:44Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available athttp://dv1litvip.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unlessyou have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and youmay use content in the JSTOR archive only for your personal, non-commercial use.Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained athttp://www.jstor.org/action/showPublisher?publisherCode=informs.Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printedpage of such transmission.JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range ofcontent in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact [email protected] is collaborating with JSTOR to digitize, preserve and extend access to Interfaces.http://dv1litvip.jstor.org

Finance Theory and Financial StrategySTEWART C. MYERS Sloan School of ManagementMassachusetts Institute of TechnologyCambridge, Massachusetts 02139Despite its major advances, finance theory has had scant impact on strategic planning. Strategic planning needs financeand should learn to apply finance theory correctly. However,finance theory must be extended in order to reconcile financialand strategic analysis.Strategie planning is many things, butit surely includes the process of dedeciding how to commit the firm's resourcesacross lines of business. The financial sideof strategic planning allocates a particularresource, capital.Finance theory has made major advances in understanding how capitalmarkets work and how risky real and financial assets are valued. Tools derivedfrom finance theory, particularly discounted 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:(1) Finance theory and traditional approaches to strategic planning may bekept 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 together, add up to the whole truth. Nevertheless, I will describe both the problemsencountered in applying finance theory tostrategic planning, and the potentialpayoffs if the theory can be extended andCopyright ? 1984, The Institute of Management Sciences0092-2102/84/1401/0126$01.25PLANNING ? CORPORATEFINANCE ? CORPORATE FINANCEINTERFACES 14: 1 January-February 1984 (pp. 126-137)

FINANCE THEORYproperly applied.The first task is to explain what ismeant by "finance theory" and the gapbetween it and strategic planning.The Relevant TheoryThe 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. We

calculate net present value (NPV) by subtracting the required investment.In other words, we calculate each project's present value to investors who havefree access to capital markets. We shouldtherefore use the valuation model whichbest explains the prices of similar securities. However, the theory is usually boileddown to a single model, discounted cashflow (DCF):T CtPV= V-?,M (i + rywhere PV =present (market) value;Ct= forecasted incremental cash flowafter corporate taxes ?strictlyspeaking the mean of the distribution of possible C/s;T =project life (CT includes any salvage value);r = the opportunity cost of capital,defined as the equilibrium expected rate of return on securitiesequivalent in risk to the projectbeing valued.NPV equals PV less the cash outlay required at t = 0.Since present values add, the value ofthe firm should equal the sum of the values of all its mini-firms. If the DCF formula 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 intangible as well as tangible assets, andgrowth opportunities as well as assetsin-place. Intangible assets and growthopportunities are clearly reflected in stock

prices, and in principle can also be valuedin capital budgeting. Projects bringing intangible assets or growth opportunities tothe firm have correspondingly higherNPVs. I will discuss whether DCF formulas 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 valueweighted 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 discountJanuary-February 1984 127

MYERSrate.Finance theory stresses cash flow andthe expected return on competing assets.The firm's investment opportunities compete with securities 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 fundamentals. It should not be deflected by accounting allocations, except as they affect cashtaxes. For example, suppose a positiveNPV project sharply reduces book earn

ings in its early stages. Finance theorywould recommend forging ahead, trusting investors to see through the accounting bias to the project's true value. Empirical 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 accepted by financial economists. The concepts are broadly consistent with an upto-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 PlanningI have resisted referring to strategicplanning as "capital budgeting on a grandscale," because capital budgeting in practice is a bottom-up process. The aim is tofind and undertake specific assets or projects 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 increases by more than the amount of capital committed ? otherwise they are

throwing money away. In other words,there is an implicit estimate of net presentvalue.This would seem to invite the application 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 corporate strategy [Fruhan 1979; Salter andWeinhold 1979; and Beirman 1980]. Consulting firms have developed the concepts' strategic implications [Alberts1983].Nevertheless, I believe it is fair to saythat most strategic planners are notguided by the tools of modern finance.Strategic and financial analyses are notreconciled, even when the analyses are ofINTERFACES 14:1 128

FINANCE THEORYthe 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 objectives. 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 finance 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 accounting 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. Corporate 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 components separately traded. Closed-endfunds actually sell at discounts, not premiums. 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 planning seems extremely naive from a financial point of view. Sometimes capital markets are ignored. Sometimes firms are essentially 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 capital, the proper standard for new investment by the firm.The practical conflicts between financeand strategy are part of what lies behindthe recent criticism of US firms for allegedly concentrating on quick payoffs atthe expense of value. US executives,especially MBAs, are said to rely toomuch on purely financial analysis, and

too little on building technology, products, 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, spin offs, unusual securities, and complex financingpackages when they should be out on thefactory floor. They pump up current earnings per share at the expense of long-runvalues.Much of this criticism is not directedagainst finance theory, but at habits of financial analysis that financial economistsare attempting to reform. Finance theoryof course concentrates on the financialworld ? that is, capital markets. However, it fundamentally disagrees with theimplicit assumption of the critics, who saythat the financial world is not the realJanuary-February 1984 129

MYERSworld, 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 attack too. Some feel that any quantitativeapproach is inevitably short-sighted.Hayes and Garvin, for example, haveblamed discounted cash flow for a significant 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 cardcarrying financial economists.I do not know whether "gap" fully describes all of the problems noted, orhinted at, in the discussion so far. Insome quarters, finance theory is effectively 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 ProblemFinance theory and strategic planningcould be viewed as two cultures lookingat the same problem. Perhaps only differences 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 withStandard discounted cash flow analyses ofa series of major projects:(1) Even careful analyses are subject torandom error. There is a 50 percentprobability of a positive NPV for atruly border-line project.(2) Firms have to guard against these errors dominating project choice.(3) Smart managers apply the followingcheck. They know that all projectshave zero NPV in long-run competitive equilibrium. Therefore, a positiveNPV must be explained by a short-rundeviation from equilibrium or by somepermanent competitive advantage. Ifneither explanation applies, the positive NPV is suspect. Conversely, anegative NPV is suspect if a competitive 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 implement 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 identifies a competitive advantage, then (efficient) investment in that line must offerprofits exceeding the opportunity cost ofcapital. No need to calculate the investment's NPV: the manager knows in advance that NPV is positive.INTERFACES 14:1 130

FINANCE THEORYThe trouble is that strategic analyses arealso subject to random error. Mistakes arealso made in identifying areas of competitive advantage or out-of-equilibrium markets. 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 finance theory is more than just "two cultures and one problem."The next step is to ask why reconciliation is so difficult.Misuse of Finance TheoryThe gap between strategic and financialanalysis may reflect misapplication of finance theory. Some firms do not try touse theory to analyze strategic investments. Some firms try but make mistakes.I have already noted that in many firms

capital 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 arbitrary or unpredictable. Over time, thesesacrifices appear as disappointing growth,eroding market share, loss of technological leadership, and so forth.The non-financial approach taken inmany strategic analyses may be an attempt to overcome the short horizons andarbitrariness of financial analysis as it isoften 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 ReturnCompeting 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 projects tend to be put down the list even iftheir net present value is substantial.The internal rate of return does measure 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 inside the firm, in order to control an organization too eager to spend money.Even when a firm does have a strictly limited pool of capital, it should not use theinternal rate of return to rank projects. Itshould use NPV per dollar invested, orlinear programming techniques when capital is rationed in more than one period[Brealey and Myers 1981, pp. 101-107].Inconsistent Treatment of InflationA surprising number of firms treat inflation inconsistently in DCF calculations.High nominal discount rates are used butJanuary-February 1984 131

MYERScash flows are not fully adjusted for future inflation. Thus accelerating inflationmakes projects?especially long-livedones ? look less attractive even if theirreal value is unaffected.Unrealistically High RatesSome firms use unrealistically high discount 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 thatcan easily be diversified away instockholders' portfolios.(2) Rates are raised to offset the optimisticbiases of managers sponsoring projects. 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-risk

once 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, shortlived projects are artificially favored.Discounted cash flow analysis is alsosubject to a difficult organizational problem. Capital budgeting is usually abottom-up process. Proposals originate inthe organization's midriff, and have tosurvive the trip to the top, getting approval at every stage. In the process political alliances form, and cash flow forecastsare bent to meet known standards. Answers ? not necessarily the right ones ?are worked out for anticipated challenges.Most projects that get to the top seem tomeet profitability standards set by management.According to Brealey and Myers's Second Law, "The proportion of proposedprojects having positive NPV is independent 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 extremely difficult for top management toverify the true cash flows, risks and present value of capital investment proposals. That would explain why firms do nottry to reconcile the results of capitalbudgeting and strategic analyses. However, it does not explain why strategicplanners do not calculate their ownNPVs.We must ask whether those in topmanagement? the managers who makestrategic decisions ? understand finance

theory well enough to use DCF analysiseffectively. Although they certainlyunderstand the arithmetic of the calculation, 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 capital market data effectively. The widespread 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 toINTERFACES 14:1 132

FINANCE THEORYaccept its verdict on how well the firm isdoing.Finance Theory May Have Missed the BoatNow consider a firm that understandsfinance theory, applies DCF analysis correctly, and has overcome the human andorganizational problems that bias cashflows and discount rates. Carefully estimated net present values for strategic investments should help significantly.However, would they fully grasp and describe 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 approaches 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 thefirm's other assets' cash flows, that isthrough the cross-sectional links between projects, and(4) Estimating the project's impact on thefirm's future investment opportunities. 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 review all four.Estimating the Opportunity Cost of CapitalThe opportunity cost of capital will always be difficult to measure, since it is anexpected rate of return. We cannot commission the Gallup Poll to extract probability distributions from the minds of investors. However, we have extensive evidence 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. Reasonable, ballpark cost of capital estimatescan be obtained if obvious traps (forexample, improper adjustments for risk orinflation) are avoided. In my opinion, estimating cash flows properly is more important than fine-tuning the discount rate.Forecasting Cash FlowIt's impossible to forecast most projects'actual cash flows accurately. DCF calculations 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 for

the 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 about. Second, he is asked to express hisforecast in accounting rather than operating variables. Third, incorporating forecasts of macroeconomic variables is difficult. As a result, long-run forecasts oftenend up as mechanical extrapolations ofshort-run trends. It is easy to overlook thelong-run pressures of competition, inflation, and technical change.January-February 1984 133

MYERSIt should be possible to provide a betterframework for forecasting operating variables 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 information 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 FlowsTracing "cross-sectional" relationshipsbetween project cash flows is also intrinsically difficult. The problem may be mademore difficult by inappropriate project definitions or boundaries for lines of businesses. Defining business units properlyis one of the tricks of successful strategicplanning.However, these inescapable problemsin estimating profitability standards, future 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 between finance theory and strategic planning.The Links Between Today's Investmentsand Tomorrow's OpportunitiesThe fourth problem? the link betweentoday's investments and tomorrow's opportunities? is much more difficult.Suppose a firm invests in a negativeNPV project in order to establish a foothold in an attractive market. Thus a valuable second-stage investment is used tojustify the immediate project. Thesecond-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 today'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 together?You would not get the right answer.The second stage is an option, and conventional discounted cash flow does notvalue options properly. The second stageis an option because the firm is not committed 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: a

call option on Stage 2. If the option's present value offsets the first stage's negativeNPV, the first stage is justified.The Limits of Discounted Cash FlowThe limits of DCF need further explanation. Think first of its application to fourtypes of securities:(1) DCF is standard for valuing bonds,preferred stocks and other fixedincome securities.(2) DCF is sensible, and widely used, forvaluing relatively safe stocks payingregular dividends.(3) DCF is not as helpful in valuing companies with significant growth opportunities. The DCF model can beINTERFACES 14:1 134

FINANCE THEORYstretched to say that Apple Computer's stock price equals the presentvalue of the dividends the firm mayeventually pay. It is more helpful tothink of Apple's price, P0f as:FPSPo= =PVGO,whereEPS = normalized current earningsr = the opportunity cost of capitalPVGO = the net present value of futuregrowth 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 DCFto 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 "engineering investments," such asmachine replacements, where themain benefit is reduced cost in aclearly-defined activity.(3) DCF is less helpful in valuing businesses with substantial growth opportunities or intangible assets. In otherwords, it is not the whole answerwhen options account for a large fraction 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, convertibles, 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 decisions 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 option which increases the value of theoption to bail out of a poorly performing 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. However, these real options last longer and aremore complex than traded calls and puts.The terms of real options have to be extracted from the economics of the problemat hand. Realistic descriptions usuallylead to a complex implied "contract," requiring numerical methods for valuation.Nevertheless, option pricing methodshold great promise for strategic analysis.January-February 1984 135

MYERSThe time-series links between projects arethe most important part of financialstrategy. A mixture of DCF and optionvaluation models can, in principle, describe these links and give a better understanding of how they work. It may also bepossible to estimate the value of particularstrategic options, thus eliminating onereason for the gap between finance theoryand strategic planning.Lessons for Corporate StrategyThe task of strategic analysis is morethan laying out a plan or plans. Whentime-series links between projects are important, it's better to think of strategy asmanaging the firm's portfolio of real options [Kestler 1982]. The process of financial planning may be thought of as:(1) Acquiring options, either by investingdirectly in R&D, product design, costor quality improvements, and soforth, or as a by-product of direct capital investment (for example, investingin a Stage 1 project with negative NPV

in 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 assets that ultimately produce positive net present value.There is also a lesson for current applications of finance theory to strategic issues. 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 intangibles is not ignored by good managerseven when conventional financial techniques miss them. These values may bebrought in as "strategic factors," dressedin non-financial clothes. Dealing with thetime series links between capital investments, and with the option value theselinks create, is often left to strategic planners. But new developments in financetheory promise to help.Bridging the GapWe can summarize by asking how thepresent gap between finance theory andstrategic planning might be bridged.Strategic planning needs finance. Present value calculations are needed as acheck on strategic analysis and vice versa.However, the standard discounted cashflow techniques will tend to understatethe option value attached to growing, profitable lines of business. Corporate financetheory requires extension to deal with realoptions. Therefore, to bridge the gap weon the financial side need to:(1) Apply existing finance theory correctly.(2) Extend the theory. I believe the most

promising line of research is to try touse option pricing theory to model thetime-serie s interactions between investments.Both sides could make a conscious effort to reconcile financial and strategicanalysis. Although complete reconciliation 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.INTERFACES 14:1 136

FINANCE THEORYReferencesAlberts, W. A. and McTaggart, James M. 1984,"Value based strategic investment planning,"Interfaces, Vol. 14, No. 1 (January-February),pp. 138-151.Bierman, H. 1980, Strategic Financial Planning,The Free Press, New York.Brealey, R. A. and Myers, S. C. 1981, Principles of Corporate Finance, McGraw-Hill BookCompany, New York.Foster, G. 1978, Financial Statement Analysis,Prentice-Hall, Inc., Englewood Cliffs, NewJersey.Fruhan, W. E., Jr., 1979, Financial Strategy:Studies in the Creation, Transfer and Destructionof Shareholder Value, Richard D. Irwin, Inc.,Homewood, Illinois.Hayes, R. H. and Garvin, D. A. 1982, "Managingas if tomorrow mattered," Harvard Business Review, Vol. 60, No. 3 (May-June), pp.70-79.Holland, D. M. and Myers, S. C. 1979,"Trends in corporate profitability and capitalcosts," in R. Lindsay, ed., The Nation's Capital Needs: Three Studies, Committee on Economic Development, Washington, DC.

Ibbotson, R. G. and Sinquefield, R. A. 1982,Stocks, Bonds, Bills and Inflation: The Past andthe Future, Financial Analysts ResearchFoundation, Charlottesville, Virginia.Myers, S. C. and Majd, S. 1983, "Applying option pricing theory to the abandonment valueproblem," Sloan School of Management,MIT, Working Paper.Paddock, J. L.; Siegel, D.; and Smith, J. L.1983, "Option valuation of claims onphysicalassets: the case of offshore petroleumleases," Working Paper, MIT Energy Laboratory, Cambridge, Massachusetts.Salter, M. S. and Weinhold, W. A. 1979, Diversification Through Acquisition, The FreePress, New York.January-February 1984 137