Capital allocation aims to maximize shareholder value by deploying capital in ways that generate the greatest return.
The purpose of capital allocation is to improve company performance by investing in growth opportunities and reducing or eliminating underperforming or non-essential businesses. Capital allocation decisions should be made with a long-term perspective, as opposed to being based on short-term financial results.
Running a business takes work. There are a lot of factors that come into consideration, such as resources, finance, and management. There are a lot of examples of organizations that recorded great success but failed to manage their finances well, leading to their untimely demise. Prevention is always better than cure, so why not learn from those mistakes and ensure you don’t fall into those same traps? After all, a balanced capital allocation for your business will ensure it stays healthy for a long time.
What is Capital Allocation?
Capital allocation is a term used to describe allocating capital to different projects. Capital allocation is a crucial part of any business, as it can help you decide which projects are worth investing in and how much money should be spent on each project.
Capital allocation can be a complex process, especially if you have a lot of different projects that need funding. Many companies allocate capital using a portfolio management approach, which involves creating an investment portfolio with different groups of investments.
For example, imagine that you own a company that makes two products: blue hats and red hats. The blue hat costs $5 to make and sells for $10; the red hat costs $5 to make and sells for $20. You have 100 blue hats in stock and 100 red hats in stock. You need more blue hats because they sell faster than red ones, however the challenge is that you are cash constrained.
In this situation, it wouldn’t make sense for your company to spend all its money producing blue hats even though blue hats are cheaper to produce than red ones. Instead, you would use some of your cash to make some blue hats and some red ones so that you could sell both products simultaneously without running out of either one.
Capital Allocation Process
The Capital Allocation Process is a method of allocating capital by considering both risks and returns. It is used to allocate capital to investments with the highest probability of producing the highest returns.
The Capital Allocation Process uses the following steps:
1) Identify the investment criteria, such as risk tolerance, return expectations, and time horizon.
2) Review the portfolio and identify potential investments based on these criteria.
3) Compare each potential investment to your current portfolio and determine if it would be better than your current holdings or not. If it would be better, make a note of it for later consideration. If not, then proceed to the next step.
4) Create a table listing all potential investments and their characteristics. Rank them from best down to worst. When ranking them, consider only those investments that meet your criteria. If you don’t want any high-risk ventures, don’t consider anything with an above-average risk level.
The Zeroth Law of Capital Allocation
Capital allocation is a strategic tool for managing risk and achieving long-term goals by making investments that support future growth and profitability.
Capital allocation decisions should be based on a clear understanding of how each investment relates to achieving strategic objectives. The first step in making such decisions is determining what kind of business you want to be in and how much capital each division requires to achieve its goals.
The second step is deciding how much money should be allocated to each division based on its contribution toward meeting strategic objectives. Once this decision has been made, it becomes easier to decide on specific projects within each division that should receive funding or be cut entirely.
The Zeroth Law of Capital Allocation states that one should invest in whatever she thinks will be the most profitable investment, regardless of how good it is for society.
The Zeroth Law of Capital Allocation is a counterpoint to the first law. The first law says you should invest in whatever will be best for society. The zeroth law says you should invest whatever will make you money. It’s a parable from Jesus: You get what you give.
The zeroth law is certainly not without its problems, but let’s start with some strengths:
It makes it clear that capital allocation decisions are about profit maximization and are not meant to serve any other purpose. It also emphasizes that these decisions are made at the individual level. It puts less pressure on managers and investors by relieving them of any need to be responsible for their actions or feel guilty about them.
Now let’s look at some weaknesses:
The zeroth law assumes that people are rational self-interested actors who behave according to their self-interests alone; however, this isn’t always true! People often act against their own for the good of society.
Options for Using Capital
1. Strengthen the balance sheet
Capital is an important part of a company’s balance sheet. The balance sheet shows a company’s assets, liabilities, and shareholder equity at one point in time. For a company to continue operating as a going concern, it must have enough capital to cover its liabilities and obligations. There are many ways that companies can strengthen their balance sheets.
One way is by issuing new shares of stock. This will help raise money for the company and increase its shareholder equity. A company can also use retained earnings or sell off some of its assets to raise cash. This can be done through asset sales or by borrowing money from investors willing to lend them money on favourable terms to both parties involved in the transaction.
2. Grow the business
For your business to grow, you need cash. You can get cash by raising money from investors or selling off your company’s equity. The more capital at your disposal, the more money you can spend on hiring new employees, increasing your marketing budget, and exploring new markets.
Here are some of the ways you can use capital to grow your business:
Capitalize on an opportunity. Perhaps there’s an unmet need in the market that you can fill with a new product or service. If so, it makes sense to invest in research and development into that product or service before launching it, even if it means taking on debt or selling equity in your company.
The same goes for hiring new employees to help build this product or service. This is what venture capitalists do when they invest in startups: They’re investing in growth potential because they believe the returns will be greater than their investment over time.
Expand into new markets. If you have grown sales locally but not nationally yet, it may be time to expand into other geographic regions. This may require additional capital.
3. Returning capital to shareholders
The third option is returning capital to shareholders. A company could do this by paying out a dividend or buying back its stock.
Returning capital to shareholders is often the most popular option. It’s easy to understand and doesn’t require much effort from management. When a company pays dividends, it passes part of its profits to shareholders. The amount that each investor receives depends on how many shares they own and how much money the company makes. When companies buy back their shares, they reduce the number of outstanding shares by buying them from investors at a price above what those shares are worth.
Most companies don’t return capital directly to shareholders because it can be expensive and risky for them to do so. For example, if a company pays out too much in dividends or buys back shares at the wrong time, it could hurt its long-term growth prospects by reducing its available funds for investment.
Paying dividends can also lead to less efficient capital allocation if there aren’t enough opportunities for investment within the company because all of the profits have already been paid out as dividends. Companies that pay out dividends will often have lower returns on equity than those that don’t pay dividends because they’re using less of their profits.
To make the best capital allocation decisions, assess each of your projects individually and separately, as one of them might be a diamond in the rough that has the potential to skyrocket. The bottom line is that you want to allocate your capital to balance the risk and return. So if you have a great idea but very little capital, put something small into it. If it works out for you, make sure to invest more money next time. And if it fails, cut your losses; there is no need to put even more money into something that is not working for you. Finally, if you would like assistance to help with your capital allocation decision, do not hesitate to engage the specialists at FH Consulting.
Capital Allocation Process
The Purpose of Capital Allocation
The General Theory of Capital Allocation
The Zeroth Law of Capital Allocation
The Five Tools of Capital Allocation (and When to Use Them)
Capital Allocation Don’ts