Capital Allocation

Capital allocation is the process of Sourcing an appropriate mix of Capital (funds) and then optimally Deploying this Capital across a universe of Investments.

Value can only be generated when the Return on Investment exceeds the Cost of Capital.

Our Capital Allocation Model is ideally placed to assist your business with the dynamic, and optimal, allocation of its capital.

Anyone who has studied Finance will have come across Capital Budgeting. With it, a fixed amount of Capital is allocated across a Universe of Investments, the combined value of which usually exceeds the size of Available Capital. Therefore, in choosing the optimal investments, some ranking technique along with metrics such as Net Present Value (“NPV”), Internal Rate of Return (“IRR”), Payback Period etc. are used.

Unfortunately, there are a couple of limitations to this approach. Firstly, the Available Capital is usually not fixed and can be increased or decreased, albeit with an impact on the Cost of this Capital. Secondly, far too much attention is given to the Returns of the Investments as opposed to the Risks that underpin these Returns.

For a Business to Create Value, the Return on its Investments (“ROI”) should exceed the Cost of Available Capital. Because a Business will use a mix of capital, such as Ordinary Shares, Preference Shares and Interest-Bearing Debt, we often refer to this Cost of Available Capital as the Weighted Average Cost of Capital (“WACC”). The same thinking can be applied to the Equity of the Business, whereby the Return on Equity (“ROE”) should exceed the Cost of Equity (“Ke”).

So what does this all mean?

Well, Capital Allocation is therefore a Strategic process, and should involve the following key steps:

  1. Determining the ideal Mix of Capital.
  2. Optimally Deploying this Mix of Capital, on the basis of Risk-Adjusted Returns, across a Universe of Investments.

This idea of Risk-Adjusted Returns is so important. For example, let us look at two investment opportunities, Alpha and Beta. Alpha may have an excellent expected ROA but a high risk associated with generating that ROA. In contrast, Beta may have a lower expected ROA but may be far more attractive on the basis of risk-adjusted returns. It is, of course, possible to reduce risk through Diversification, and this is where Capital Allocation really does become useful.

There is, of course, never a single “correct” capital allocation strategy, and different investors will be comfortable with different Risk-Return profiles. The point is more that the Capital Allocation decision-making process would be incomplete without careful consideration of both Returns and Risks.

Please Contact us for more information on how we can assist you with the construction of Capital Allocation Financial Models.