Easy Notes - By Manoj Singh

Calculation of IRR (Internal Rate of Return) is bit tedious so i have tried to break the steps in simpler and easy to understandable form. For understanding IRR in detail, please refer to my separate post on this.

Internal Rate of Return is one of the most frequently discussed discounted cash flow technique in capital budgeting. This is one of the best tools for making investment decisions, especially important when you have two mutually exclusive projects. IRR is basically the discount rate at which present value of future after tax cash flows equals the total investment outlay. In other words, this is discount rate which produces a zero NPV (Net present value). Hence, at this rate, present value of cash inflows equals the present value of cash outflows.

There are various activities involved in order to make the final product available to customers & most of the companies generally involve themselves in one activity of the value chain. E.g. assembly & packaging out of other activities as mentioned in the value chain (See fig. below).  Sometimes, In order to strengthen the position over suppliers or distributors or service providers, companies add up one or more activities either towards raw material or towards end users (See fig.1 below). This strategy of adding up one or more activities is called Vertical integration. Example, Car manufacturing company acquires Tyre manufacturing company or ancillary parts manufacturing company (producing important auto parts) in order to solve their raw material shortage problems and reduce other relevant costs.

You may find few companies which prefer to control each and every activity starting from Raw material to Marketing & Sales and sometimes after sales service as well. E.g. Oil companies, Smartphone manufacturers & many more. Hence, level of integration may vary from industry to industry. Option is left with the companies that whether they want to integrate fully or partially?

Types of Vertical Integration

There are 3 types of Vertical Integration
Backward integration: If company is moving towards source of raw materials then it has adopted backward integration strategy. E.g. adding up manufacturing facility to start production of ancillary products (which was bought earlier from supplier) to support the production process. By doing this, companies can reduce their interdependencies on supplier and gain through reduction in input costs.

Forward integration: If company is adding few activities which make them nearer to the end users then this strategy is known as forward integration. E.g. establishing own distribution network or after sales service centre. E.g. Apparels manufacturer set-up its own stores throughout country and starts selling to customers directly.

Balanced integration: When company has gained control over one step backward and one step forward of the value chain then it is said that they are following balanced integration strategy. In other words, it is combination of both forward & backward integration strategies.

Advantages of Vertical Integration
1. Control over value chain: This strategy helps a lot in gaining control over various activities under value chain.
2. Barriers to entry: Huge capital investment is required for implementing this strategy. Hence, this huge investment creates an entry barrier for new entrants and thus improves the overall position of the company.
3. Reduced production cost: As there are no intermediaries’ & manufacturer’s margin and company is enjoying the benefits of economies of scale, cost of production is bound to decline.
4. Competitive advantage: Economies of scale produces cost effectiveness & barriers to entry. This in turn leads to competitive advantage.
5. Quality product: When you have better control over the production activities & raw materials, then quality of final goods automatically gets improved because of increased supervision & control.
6. Control over scarce resources: Through controlling over raw materials which are scarce & limited, companies have an advantage over competitors as unavailability of the same can cause serious problems to big industrial setup. Think of power companies owning coal blocks, oil companies owning gas basins.

Disadvantages of Vertical Integration
1. Can’t be reversed back: Most important drawback of this strategy is that it couldn’t be reversed back and can prove very fatal if it backfires. Hence, special care is taken while taking or implementing any of the vertical integration strategies.
2. Expensive: These are very expensive as it requires lot of capital infusion into new business line / activity.
3. Expertise issue: Initially you might face with this problem because of lack of experience in added line of businesses resultant from adaptation of any strategies as mentioned above.