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Explain the relationship between strategic management and competitive advantage for firms. How can a firm achieve sustained competitive advantage?
Strategic management is all about gaining and maintaining competitive advantage. Competitive advantage is anything a firm does especially well compared to rival firms. When a firm can do something that rival firms cannot do, or owns something that rival firms desire, that can represent a competitive advantage.
Getting and keeping competitive advantage is essential for long-term success of an organization.
A firm must strive to achieve sustained competitive advantage by
(1) continually adapting to changes in external trends and events and internal capabilities, competencies and resources, and by
(2) effectively formulating, implementing and evaluating strategies that capitalize upon those factors.
The goal is to maximize the overall market value of all the securities issued by the firm. Think of the financial manager as taking all the firm’s real assets and selling them to investors as a package of securities. Some financial managers choose the simplest package possible: all-equity financing. Others end up issuing dozens of types of debt and equity securities. The financial manager must try to find the particular combination that maximizes the market value of the firm. If firm value increases, common shareholders will benefit.
2. Does firm value increase when more debt is used?
Not necessarily. Modigliani and Miller’s (MM) famous debt irrelevance proposition states that firm value can’t be increased by changing capital structure. Therefore, the proportions of debt and equity financing don’t matter.
Financial leverage does increase the expected rate of return to shareholders, but the risk of their shares increases proportionally. MM show that the extra return and extra risk balance out, leaving shareholders no better or worse off. Of course MM’s argument rests on simplifying assumptions. For example, the argument assumes efficient, well-functioning capital markets and ignores taxes and costs of financial distress. But even if these assumptions are incorrect in practice, MM’s proposition is important. It exposes logical traps that financial managers sometimes fall into, particularly the idea that debt is “cheap financing” because the explicit cost of debt (the interest rate) is less than the cost of equity. Debt has an implicit cost too, because increased borrowing increases financial risk and cost of equity. When both costs are considered, debt is not cheaper than equity. MM show that if there are no corporate income taxes, the firm’s weighted-average cost of capital does not depend on the amount of debt financing.