Best Strategy Ignoring the Predictions of HB Forecasting Team - Term Paper Example

Finance Table of Contents Executive Summary 2 Best Strategy considering the predictions of HB forecasting team 6 Concerns about the process 7 Choice of assumptions 8 Cost of availing consultancy services 10 Issues to be negotiated with the consulting company 11 Executive Summary Hertfordshire Bank (HB) has witnessed a steady growth in its operation over the past twenty years. The bank is currently facing the problem of increased market competition and global crisis. This has posed a number of challenges for the bank. For improving its business operations the bank has to review its business strategy. There are three strategies that the bank can adopt. It can opt for organic growth or acquire the UK banks or the European banks. The outcome of the strategy is based on various business and regulatory factors. However the management board of the bank is mainly considering the prospect of economic recovery and regulatory approval by the authorities. The choice of the ideal strategy should be based on the regulatory restrictions and the pattern of economic recovery. Different weights have been assigned to the possibilities of economic recovery; like it has been assumed by the management board that the possibility of flat and positive growth to be 50 percent. Likewise the management is more optimistic about the full approval as is evident from the higher weights assigned to it. The management board assumes a higher number of average customers in the case of positive growth whereas this figure declines in the case of flat growth. For the determination of the best strategy the company has to take into account the average number of customers, number of branches, revenue and the costs incurred in all the possible scenarios. These are then adjusted with the probability of recovery pattern and economic growth to identify the best strategy. The best strategy is the one which yields the highest amount of profit for the bank. In devising the strategies the management board of the bank must also consider other economic factors like the pattern of demand, investment behaviour, and availability of man-power. Since the revenue estimates of the customers are subjected to biases as they are not based on any evidence and lack a logical explanation, therefore the inclusion of investment behaviour and anticipated level of demand is important while determining the correct amount of revenue. For predicting important figures like demand for banking services in an economic environment, the bank can seek the opinion of the economists. These factors are actually based on macro-economic conditions and have a significant influence on investment behaviour of the people. Best Strategy ignoring the predictions of HB forecasting team The management board of Hertfordshire Bank (HB) wants to review their business strategy in view of the rising competition and the global financial crisis. In this regard the bank can adopt three strategies - it can opt for organic growth, it can acquire a UK bank or it can acquire a European bank. However the result of these strategies is based on a number of factors. Among the various factors the company must take into consideration the prospects of economic recovery and regulatory approval of bank acquisition by UK and European authorities. The HB Forecasting team of the company has predicted a 50 percent chance towards a positive economic growth. Besides they have also forecasted that the chance of full approval of acquisition is twice the chance of restricted approval. The best strategy for the company, if it ignores the prediction of HB forecasting team, is the one which would help it to earn the maximum revenue net of the variable and fixed costs. For UK branches the company has to pay an annual fixed cost of £120000. It earns revenue of £500 per customer in UK with a variable expense of £100 per customer. For European branches the company has to pay an annual fixed cost of £100000 and earn revenue worth £400 per customer with a variable expense of £70 per customer. The company can earn maximum profit of £11500000 if it opts for the acquisition of European banks. As there are no approval restrictions by the European regulators, the company can add 50 new branches in this case. Both under the flat growth scenario and the positive growth scenario the company will be able to earn the maximum profit if it opts for the acquisition of European banks. This is partly due to the absence of regulatory restrictions and partly due to the fixed cost difference of £20000. Since the fixed cost of European branches is less as compared to UK branches therefore the option of organic growth will be unprofitable both under the restrictive approval and the full approval scenario. While the acquisition of UK banks seems profitable under all circumstances yet the gain from this strategy is less when compared to the gain that will result by acquiring the European banks. In the strategy of acquisition of European banks the company does not face any regulatory restrictions and therefore can add 50 new branches. Coupled with it is the advantage that the variable expense per customer for European branches is £30 less as compared to that UK branches. Moreover the average number of customers in the European branches is also higher. Both in the case of flat and positive growth the number of customers is 600 and 1000 respectively. Even though the number of additional UK branches is limited to 45 yet the average number of customers under the flat growth and positive growth is 400 and 900 which is close to the average number of customers of the European branches. Lesser number of branches and higher fixed and variable costs makes the strategy of acquiring European branches more profitable than that of UK branches. Moreover there are regulatory restrictions in the acquisition of UK branches and in the case of restricted approval the number of UK branches that the company can add is only 30. In the event of a flat growth the profit earned from the addition of UK branches is £1200000, which is less than one –third the profit earned under the flat growth scenario in the acquisition of European banks. Even when there is a positive growth the profit earned is £7200000 which is less as compared to £11500000 of the European branches. In the case of organic growth the number of branches that can operate under restricted approval is 20 which can utmost rise up to 60 under full approval. However the company failed to earn profits even after the rise in the number of branches. This can be partly attributed to higher costs. The fixed cost in the case of organic growth is higher by £20000 per branch when compared to that of the European branches. Other than this the company assumes the number of customers to be 100 and 250 in the event of flat and positive growth respectively. This is nearly one-fourth the numbers of customers of the European branches. Due to the high fixed and variable expenses and a low customer base the company fails to recover its costs thereby earning a loss in all the four situations (Buchheit, n.d. P 2). Though the number of maximum branches can be 60 the loss is incurred because the number the limited customer base per branch raises the costs of the company. Considering the limited customer base it would be ideal for the company to reduce the number of branches in the case of organic growth so that the fixed cost is significantly reduced. Therefore the best strategy for the company is to acquire European banks as this yields the highest profit both under the flat and positive growth scenarios. Best Strategy considering the predictions of HB forecasting team The forecasting team of HB has predicted that the chance towards positive growth is 50 percent or 0.50. Therefore the chance of flat growth is also 0.50. The team has also forecasted the chances of full approval to be twice the chances of restricted approval i.e. the probability of full approval to restricted approval is 2:1 which comes to 0.67 for full approval and 0.33 for restricted approval. In the first step the profit or loss earned during the event of flat or positive growth is multiplied with 0.50 each as the probability of both the outcome is the same. The figure thus obtained is multiplied with 0.67 for full approval and 0.33 for restricted approval which gives the amount that the company expects to earn under the three different strategies (Jones, n. d.; Techet, 2005). Considering the predictions of the HB forecasting team the company should adopt the strategy of acquisition of European banks. A profit of £820000 will be earned by the company if it does so. On the other hand the company incurs a loss of £2340000 in the strategy of organic growth whereas it earns a profit of only £5607000 in the strategy of acquisition of UK banks. As the company earns the highest profits under the strategy of European bank acquisition, it can be inferred that this strategy is best for the company. Concerns about the process The method of finding out the best strategy is not very reliable as this ignores various significant factors. Moreover the assumption on which factors such as average customers, revenue, and number of branches are deduced is highly subjective as it is a mere estimate and is not based on any logical reasoning. The management board of the company has assumed a higher number of average customers in a positive growth situation. However no logical reason has been given regarding the varying number of average customers for the UK and other European branches. It has assumed the highest number of average customers to be 1000 in the case of acquisition of European bank but no reason for this assumption has been mentioned. The possibility of economic recovery and regulatory approval by the management board are mere estimates. These are however crucial factors and need an expert opinion. The revenue of the bank depends on crucial factors like investment behaviour of the people which has not been taken into account during the selection procedure of the strategy. Ideally the company should take the opinion of the economists in determining the number of average customers. Choice of assumptions The management of the company has taken into consideration two factors-prospects of economic recovery and regulatory approval of the UK and European authorities in the acquisition of banks- in determining the outcome of a strategy. It assumes the possibility of flat and positive growth to be 0.50 each and is more confident about a full approval as is evident from the high percentage allocated by the company to this situation. Besides this the management team has assumed the customer base to be the highest for the European branches which is 1000 under positive growth, and supposed the lowest growth to be 100 customers in the case of organic growth. The number of branches in the event of full and restricted approval is also an assumed figure. The number of branches as well as the number of customers are both subjective estimates and are not supported by any logical explanation. This creates doubt regarding the authenticity of the estimated figures as they are subjected to biases. Consequently while determining the estimates; the company must take the expert opinion of economists (Katona, Morgan, 1952). The economists are adept in predicting the demand of a product or service in an uncertain situation. Long-term estimates of major airlines companies are thereby based on econometric modelling. If the historical data relating to an event is not available then the demand can be predicted through market research (Holloway, 2003). The investment behaviour of the customer must also be taken into account while determining the profits. The HB management has assumed the revenue to be the same for both the flat and the positive growth scenario. This may not be true as the investment and borrowing needs of the customer is influenced by the economic condition prevailing in the market. Generally the people are cautious during bad market conditions. They refrain from making new investments as they are worried about its profitability. This has an impact on the bank lending. Even though the banks may be willing to lend, the people remain cautious of borrowing. During difficult economic conditions the market demand is bad for all the sectors. Therefore no matter where the borrowed money is invested the chance of making any positive gains out of an investment is remote. As a result the credit flow of the banks remains low in such situations. The limited credit growth hampers the income margin of the banks. The investors also remain gloomy during bad economic conditions and tend to hoard money with the banks which further aggravates the problem because the banks have to pay an interest on these deposits. Banks make profit by lending the deposited money to the businessmen. However as the businessmen stall their expansion activities during these times the bank is not able to extend credit. This lowers the Net interest margin (NIM) of the banks. NIM is given as the difference between interest income earned by the banks in granting credit and the interest amount paid by the banks to the depositors. A change in the economic condition has an impact on the NIM of the bank (The University of Kansas, n. d.; World Trade Organization, 2002). This is an important factor which the management team should consider. The bank’s revenue is primarily based on the prevailing economic situation. Therefore the assumption of constant revenue in all the possible scenarios is not justified. It has been observed that the revenue of the banks reduces during bad economic conditions which impact its profitability. Due to limited credit growth and the fixed expenses the banks often find it difficult to sustain during these times. Therefore it is important that the factors which determine revenue generation are considered while devising the strategies of expansion. The expansionary plan of the bank requires skilled man-power. This is another important factor that deserves consideration during the formulation of strategies. The unavailability of skilled workforce is a major deterrent in the expansion plans of a company’s operations. It is important that the company identifies whether sufficient number of manpower resources are available for its business. If the company sets up operations ignoring this aspect then it will face difficulty in the carrying out its day to day operations. Another important factor that the company must consider is the investment habits of the customers in a particular place. If the spending pattern of the customers is very high the bank may not be able to generate deposits which will hamper the process of granting loans. A bank lends out of the deposits generated from the customers. In the absence of propensity to save, the bank may not be able to make any gains from its new operations. The inclusion of all these factors like customer behaviour, availability of skilled workers and demand for banking services should go a long way in making business-decisions. This will help in determining the correct revenue pattern and profits from an expansion. Cost of availing consultancy services For availing the consultancy services of a firm, with a history of accurate prediction, the maximum amount that the company can pay is the benefit derived from the prediction. The consulting company, with a history of predicting accurate economic recovery and regulatory decisions, will facilitate the company in finding out accurate profits. This will enable the company to take accurate decisions relating to the acquisition of banks. HB can also give the consulting company a share in the expected amount of profits for the first year. This will at least protect the company from the burden of paying to the consultants in the event of a loss. If the consulting company can forecast whether there will be a flat or positive growth, it will help HB to employ the resources in a planned manner. Once the company knows the pattern of economic growth it will be better equipped to make the decisions about the number of branches that are to be acquired. Based on this it can gather the necessary deposits or can raise money by issuing equity to the public. Once the amount is raised by the company it has to pay charges in the form of interest to the depositors and fees for raising equity. The above mentioned factors must also be taken into account before determining the profitability of the expansion plans. Issues to be negotiated with the consulting company During its negotiations with the consulting company, HB must take various factors into account. It can negotiate on payment procedure which can either be part payment of fees or final payment after the materialization of the prediction. If the prediction of the consulting company proves to be incorrect then it can negotiate for a partial refund of its consultation fees. The company can also seek for other predictions relating to average customers, general demand etc from the consulting company along with reports pertaining to economic recovery and regulatory decisions. HB can negotiate these predictions as complimentary to the main predictions. Other than UK and European banks, HB can ask for the growth and regulatory predictions of other economies. This will enable the company to make a comparative profit analysis of all the economies and choose the one with the highest profit earning potential. By availing the consultancy service, HB will become a client of the same. It can then negotiate for concessions on other services of the consultancy. It can make an agreement with the consulting company pertaining to all these matters. Reference Katona, G. Morgan, N.J. 1952. The Quantitative Study of Factors Determining Business Decisions. JSTOR. Available at: http://www.jstor.org/pss/1882077 [Accessed on February 4, 2010]. Holloway, S. 2003. Straight and level: practical airline economics. Ashgate Publishing, Ltd. The University of Kansas. No Date. Net Interest Margin. Available at: http://www.business.ku.edu/_FileLibrary/PageFile/932/UMBcase_Group4.pdf [Accessed on February 4, 2010]. Jones, J. No date. Probability Rules. Stats: Introduction to Probability. Available at: http://people.richland.edu/james/lecture/m170/ch05-int.html [Accessed on February 4, 2010]. Techet, H.A. 2005. 1. Overview of basic probability. Available at: http://web.mit.edu/13.42/www/handouts/reading-probability.pdf [Accessed on February 4, 2010]. Buchheit, S. No Date. Fixed Cost Magnitude, Fixed Cost Reporting Format, and Competitive Pricing Decisions: Some Experimental Evidence. Available at: http://buchheit.ba.ttu.edu/Buchheit%20CAR%20pre%20proof.pdf [Accessed on February 4, 2010]. World Trade Organization. 2002. Dispute Settlement Reports 1999. Cambridge University Press. Bibliography Dewar, A.J. 2002. Assumption-based planning: a tool for reducing avoidable surprises. Cambridge University Press. Association for Computing machinery. No date. How to Plan During Uncertain Times. Available at: http://www.acm.org/ubiquity/interviews/h_courtney_1.html?CFID=74688569&CFTOKEN=45571439 Varadhan, S.R.S. 2001. Probability theory. AMS Bookstore. Read More