What is Capital Allocation?
Capital allocation refers to the decisions that are made about how money is spent and received. It also refers to the decisions being made by companies about how they use their capital, and about what kind of investment strategies they can use that will help them make as much money as possible in the long run.
Capital allocation is one of the most important aspects of business because it helps guide long-term planning and strategy. With proper allocation, companies can make more money and increase their assets over time. Without proper capital allocation, a company’s performance over the long run can suffer significantly, or even collapse entirely if they are not able to make a profit with their available capital. This can make a big difference in the long run when it comes to the value of your company.
In the context of M&A, capital allocation is the process by which a company invests in businesses or other entities that provide financial returns greater than their cost of capital as a means of increasing shareholder value. re referred to active appreciation and accretion through consumption and/or disposition. The benefits of an asset can be consumed, saved, or reinvested. The capital allocation process is the key to successful acquisition.
Capital allocation consultants carry out the process in two ways: external financing and internal financing. Internal financing includes equity transactions such as M&A transactions, debt offerings (issuing bonds) and stock recapitalizations (issuing common stock), while external financing includes investing in marketable securities such as stocks or bonds issued by other companies.
Investing in marketable securities is a popular method of financing acquisitions. The underlying assumption is that the returns associated with investments in equity and debt securities would be greater than the cost of capital (i.e., 5% or 8%), thus providing shareholders with a higher return. In some cases, if a company has already acquired other companies and is cash flush and needs capital to invest or to retire debt, they can issue common stock. This practice is known as stock-based financing or internal financing. In other cases, companies that are overleveraged often use stock-based financing to retire debt in order to reduce interest expense and improve their financial ratios.
Capital allocation can also be done internally by issuing shares of common stock. However, there are several limitations in the use of stock-based capital allocation. The main constraint is liquidity. With equity capital, when a company does not have enough cash to pay the dividend (or for other reasons), it cannot sell any additional shares and will remain in a cash crunch. Accordingly, companies only use internal financing as a last resort to repurchase or retire retiring securities or to issue new shares if they can’t pay the dividend or if they intend to raise more money through debt issues.
Objective of Capital Allocation
The objective of capital allocation is to determine which sources will provide the best returns relative to the cost of capital (COC). Before deciding where to allocate funds, it is crucial that managers have a clear vision of their company’s future. The Process Inventory model, defines future growth as a combination of internal and external activities. After analyzing the company’s current position and projected growth, capital allocation consultants should allocate acquisitions or other capital-intensive investments to improve the efficiency and effectiveness of resources used in achieving future growth.
Accordingly, capital allocation can be considered as the process by which decision makers allocate the funds necessary for the achievement of profitable growth and sustained profitability. Capital allocation encompasses different activities (e.g. investment decisions, business strategy, short-term and long-term financial planning), but the key is to invest in profitable growth opportunities and projects that generate returns that exceed the cost of capital.
There are three basic ways of evaluating a proposed investment: the profitability on an ex ante basis, the profitability on an ex post basis and economic merits discussed below.
To evaluate a proposed acquisition deal on an ex ante basis, managers first need to determine whether there is any compatibility between the two companies’ existing assets and operations or products and services. If not, then it is necessary to compare financial ratios or other measures to determine whether each company can support a deal.
To evaluate an acquisition on ex post basis, managers should understand the total cost of capital, and the weighted average cost of capital. Since both are relevant, managers should also understand the marginal tax rate and how it relates to the weighted average cost of capital. In many cases, a firm’s customized developed internal metrics (e.g., revenue and return on investment) may be different from what is used by M&A professionals to determine whether a proposed deal will generate the expected returns.
Economic merit analysis is an important tool in determining whether an acquisition fits into a company’s overall strategy for growth or for reducing company-specific risk.
Many companies use their own customized metrics and performance indicators to evaluate potential acquisitions. Thus, they may use their own customized version of the TEV model. The TEV model defines a company’s value as its total expected future cash flows discounted at a required rate of return. Expected cash flow is calculated by multiplying the probability that each possible future will occur by the amount of money associated with each possible outcome (e.g., $3M if Company X generates $20M in net income). Cash flows are discounted by the rate at which companies have to pay interest on their debt. Thus, companies must compare the weighted average cost of capital to the cost of funds required to raise debt and equity.
If s deal is considered worthwhile, then the next step is to determine whether it will be profitable (i.e., it will generate returns greater than or equal to COC) under an assumption that both companies operate efficiently and manage their resources effectively.
Put simply, internal corporate financial and strategic analyses provide managers with an estimate of what kind of return they can expect on a potential acquisition. The more complex the analysis is (e.g., if the acquisition involves several companies), the more managers will pay attention to the aspects that make an acquisition attractive.
In a recent survey by corporate due diligence firm Kroll & Associates, less than 50 per cent of M&A professionals were involved in any sort of due diligence before moving forward with an acquisition. The same study found that only about one-third of completed acquisitions actually reached a closing stage; only about two-thirds were ultimately successful.
This process was first developed during World War II, when General George S. Patton used a spreadsheet to calculate the number of divisions that could be required in order to defeat Nazi Germany. This innovative new tool quickly became a significant part of military operations, and was later adopted by businesses during WWII. Even now, this spreadsheet is one of the most commonly used elements by businesses in fighting competition and making strategic decisions.
One of the main features of “The Patton Method” is its ability to analyze large amounts of data quickly and easily. This is particularly helpful when managers are confronting a large number of low-probability events that require rapid analysis that can trigger action on many fronts or allow for quick decisions regarding changing circumstances.
The advantages of this method include its rapid analysis of large amounts of data, and the presentation of results in a user-friendly format. The disadvantage, however, is that this method does not account for any changes in strategy that might occur over time.
3 Key Steps for Proper Capital Allocation
Oftentimes, CEOs and directors have difficulty making decisions about how to allocate capital. They may have a great idea for an acquisition, but they can’t justify the expense without proper data or research. Alternatively, they may have noticed a trend in an area that they believe could turn into a profit center. They just aren’t sure if it will be successful — and if it is successful, how much capital the company will need to divert in order for the initiative to succeed.
The solution is to follow a disciplined approach to asset allocation. The first step involves finding out where you are stronger and weaker than your competing firms. From there, you can determine areas of competition and which ones you should continue to focus on or eliminate them entirely.
Step 1: Analyze Your Strengths & Weaknesses. The first step in developing capital allocation is assessing where your business is strong and weak in comparison with your competitors’ businesses. This assessment should be based on the following:
- Financial Health. One of the main indicators of financial health is the level of cash held, especially in comparison to net operating assets. Look for common indicators for cash-flow generation, like unused accounts receivable, inventory, and fixed assets. If a company’s competitors are far ahead of them with these indicators but their balance sheet still shows large amounts of cash, this indicates that their financial health is weak. In such cases, the business tends to be low margin and lacks growth opportunities with which you can compete. Your only option is to minimize costs while increasing revenues and observe how your competitors react over time to these changes.
- Cost Overspending. Looking at cost of goods sold is a sure way to see how the business is performing. If overspending occurs, it indicates to you that the competitor may be trying to bolster their market share in a bid to increase overall sales and net income. While their products may be attractive, their cost may be high in comparison with your competing products or services. In such situations, you need to review your marketing strategy and growing capital expenditures as well as increasing them so you can keep up with your competitor’s overall growth strategies.
- Brand Strength. You should also assess the strength of each competitor’s brand name by comparing it against other brands in the same industry. You’ll want to make sure that the strength of your brand name is strong in comparison with the other brands’ names before making any acquisitions. For example, you may recognize a brand name as being strong but not want to fork over too much cash for it because your competitor’s products are also attractive. In such cases, you should examine each individual brand’s strengths on a case-by-case basis and determine how much money it would take for you to purchase the desired product.
- Competitive Strengths & Weaknesses. Comparing your competitors’ strengths and weaknesses will help you determine where their strengths lend themselves to improvement that could be incorporated into your business strategy. This is especially true if the company you are evaluating has a large amount of market share and is not in a position to improve its weaknesses while keeping steady growth. In such cases, your job is to purge your business model of any weak points and incorporate them into your strategy as quickly as possible. You’ll want to avoid competitors who are also offering high-growth products that can’t be incorporated into their business plan without significant expenditures and time to implement.
- Market Assistance. Another factor you should consider when assessing competitive strengths and weaknesses is the assistance from outside parties that help a company grow sales. These include government grants and subsidies, tax exemptions, and investments from wealthy individuals. If a company is receiving assistance from outside the business arena, you can assume that the company will continue to receive these outside resources. You’ll want to compare the amount of assistance your competitor receives against other competitors in the same industry.
Step 2: Determine Your Competitive Strategy. Once you’ve determined where your current competitors rate in comparison with other competing companies, you can begin to formulate a strategy for capital allocation by determining which business strategies are most effective for your business model. Before making any major investment, you should determine all of these factors so that the decision moves forward without causing a disruption in your business model when it comes time to implement it.
Step 3: Determine Your Capital Allocation. Once you’ve determined the type of products and services a business sells, you can begin to determine your capital allocation strategy. You’ll need to compare your current business model against competitors’ business models and make adjustments to your strategy based on comparative outcomes. However, it’s important that you continue to carry over the strengths of your current business model whenever possible — especially if these are in stark contrast to the weaknesses of the competitor’s business.
Capital allocation and asset allocation are important steps that you cannot put off. If you do, it could result in the limited or even nonexistent growth and profitability of your firm. It’s important to pursue this step in your capital allocation and asset allocation strategy as quickly as possible because a failure to do so can be costly in the long run.
To summarize, properly executing a complete capital allocation and asset allocation strategy will enable you to take control of your business model. By fully understanding your competition and assets, using these factors to help you make well-informed decisions about assets for your business model, and capitalizing on strengths while minimizing weaknesses, you’ll develop a competitive advantage over other similar firms.