Effective capital allocation: Example, calculation, strategies, and best practices

Turning capital into profit is a nifty art that most chief executive officers (CEOs) and chief financial officers (CFOs) partake in to drive an organization’s long-term growth and enhance its shareholder’s equity—maximizing return on investment (ROI).

Popularly known as capital allocation, the process of determining an efficient investment strategy for a company’s funds is the difference between its success and failure.

What does capital allocation mean? Definition

Capital allocation definition refers to the approach wherein an organization distributes and invests its financial resources to improve allocational efficiency, diversify its revenue streams, increase profits, and augment investor wealth.

Businesses can choose to invest in their research and development (R&D) segment, pay shareholders dividends, repurchase their shares, finance other growth opportunities, or explore other venues.

Though it sounds simple in theory, it’s anything but. Efficient capital allocation requires determining profitable investment ventures, considering their opportunity cost, examining their impact on the business, and allocating funds accordingly.

Why is efficient capital allocation important?

Since capital allocation decisions significantly impact an entity's bottom line and affect its future success, it's important to consider strategic priorities and allocate excess cash efficiently.

What is capital allocation efficiency?

Capital allocation efficiency means that businesses invest their resources in projects or venues that are the most profitable and will benefit society. Efficiently allocated capital represents growth opportunities for companies and promotes economic growth.

It ensures that resources are used optimally such that their marginal benefit to the general public is equal to their marginal cost.

What is the capital allocation process?

Typically there are four steps involved in the capital allocation process. They are:

• Looking at venues to allocate capital: The first step involves determining the venues where the organization would like to allocate its capital.
• Analyzing investment opportunities: Once the company has researched the available investment options, it’s time to gather information, create a financing plan, and monitor potential risks to develop capital allocation strategies.
• Allocating capital: This involves scheduling and prioritizing the chosen investment ventures and coordinating with management to allocate capital efficiently.
• Monitoring the allocated capital: Actual results of the invested and distributed capital are monitored and compared with the predicted numbers to assess its performance.

What is an example of allocating capital?

Let’s check out a capital allocation example to understand the concept better.

Company ADS merges with GHY for a percentage of the stocks and €10 million cash. In such a scenario, ADS can allocate the capital in a number of ways. It can repay its debt, pay its shareholders dividends, buy back its shares, acquire another company, invest in other growth opportunities, or strengthen its R&D department.

The company can invest in all of these venues or choose a few.

Key factors influencing capital allocation decisions

To inform their capital allocation decisions, businesses usually rely on the following key factors:

• Managerial familiarity and experience: A CEO’s previous work experience, professional skills, and knowledge of industry trends impact their strategic decisions. Moreover, familiarity with internal data about different segments plays an important role.
• Relationship between CEOs and their divisional managers: Since internal knowledge regarding various divisions impacts a CEO’s capital allocation decision, it’s vital for capital allocators to obtain accurate and reliable information from their divisional managers and not some distorted version.

Check the working capital requirements of each division and allocate an amount of money accordingly.

• Performance of the divisions: Gathering performance management data, such as net cash flow, and analyzing the reports to determine the business areas that are performing well and generating the most value and the areas that need help or are facing cash shortages is a key factor.

What is a capital allocation line?

A capital allocation line, asset allocation line, or capital market line showcases the level of risk an investor has to take on if they invest in one risk-free and another or more risky assets. This line displays the risk and return tradeoff and helps investors choose the amount they’d like to invest in risky and safe assets.

How to draw a capital allocation line?

To draw a capital allocation line, you need to determine the risk-to-rewards ratio of the assets. Begin by calculating the minimum variance frontier. To do that, you need to find out the assets’ expected return. For instance, you can find the returns of two assets using the following formula:

E(Rp) = w₁E(R₁) + w₂E(R₂)

Here, w represents the weight for the assets and RRR their expected returns.

Now, you need to find the correlation and covariance of the assets.

You can calculate portfolio variance using this formula:

Var(R_p) = w²1Var(R₁) + w²2Var(R₂) + 2w₁w₂Cov(R₁, R₂)

Here, Cov(R₁, R₂) represents the covariance between the assets. On the other hand, the above formula can be expressed as:

σ²p = w²1σ²1 + w²2σ²2 + 2ρ(R₁, R₂) w₁w₂σ₁σ₂

Here, ρ(R₁, R₂) is the correlation between R₁ and R₂. To determine the relationship between correlation and covariance, calculate:

ρ(R₁, R₂) = Cov(R₁, R₂)/ σ₁σ₂

The variance of the assets is directly proportional to their covariance. For instance, if the covariance is positive, the variance is higher and vice versa. This means that risk is lower when the assets have negative covariance.

Now, it’s time to plot the assets’ standard deviation on the x-axis and the expected return on the y-axis for the portfolio frontier. You can use Excel to assign the expected returns, standard deviation, and correlation data. Do this for possible weight combinations, wherein w2=1−w1w_2 = 1 - w_1w2​=1−w1​, and so on.

Finally, plot the data on a scatter chart. Generally, investors select an asset based on the upward-sloping part of the portfolio frontier, or minimum variance frontier, based on their risk preferences.

While this will help you find the minimum variance frontier, you need to find out the Sharpe ratio or slope of your capital allocation line to determine the return to reward ratio.

Sharpe ratio = (Expected Portfolio Return - Risk-free rate of return)/Standard Deviation Portfolio

Once you’ve mapped this, you’ll find out the assets’ optimized stock portfolio. The optimal risky asset portfolio is at the point where the CAL line is tangent to the minimum variance frontier.

Best practices in capital allocation

An informed and data-driven capital allocation framework that considers quantitative and qualitative metrics will allow businesses to make the best investment decisions to fuel long-term value creation. A few best practices include:

• Aligning capital allocation with business strategy: Identify and align your strategic priorities with capital allocation to drive maximum growth.
• Diversification and risk management: Diversifying your business’s investment portfolio and conducting a risk-to-reward analysis will help you immensely.
• Regular performance monitoring and review: Monitoring your investment decisions and reviewing their performance in real-time is vital to determine assets that are not performing per their forecast and no longer align with the company’s long-term goals.
• Flexibility and agility in capital allocation: Be flexible regarding your capital allocation strategy to take advantage of current market trends. Use your cash management strategies to bring in business agility.
• Communication and transparency: A company must exercise transparency and ensure that the important stakeholders understand their capital allocation strategy. Likewise, effective communication with internal and external stakeholders is essential to connect strategy with capital allocation.

Effective strategies for capital allocators

Effective strategies for capital allocators include:

• Allocate capital after careful analysis: Allocators must carefully determine the amount of capital they need to apportion for a specific business division to support their long-term strategy and will be the most profitable. Employing cash flow hedge techniques can help protect cash flow against fluctuations.
• Support investment strategies that are backed by numbers: Effective capital allocation is all about a company’s strategic goals. So it stands to reason that any investment decision be taken after careful consideration. If the numbers don’t justify an investment, allocators shouldn’t invest in that asset.
• Invest in a winning strategy, not individual projects: CEOs in charge of multiple subsidiaries often pool all of their cash reserves and distribute them per the requirements of individual companies. But, in doing so, they might sometimes fund individual projects and not strategies.

It’s important to fund the entire strategy and not excellent projects within. Alternatively, a winning strategy might constitute subpar projects. So it’s vital to strike a balance between the two and judiciously invest in strategies that support excellent rate-of-return projects.

• Consider opportunity cost: No capital is free. There’s always some opportunity cost attached to capital.
• Cut off investment that doesn’t generate value: Value innovation, but don’t invest in venues that don’t generate profit.

What is the advantage of capital allocation?

Capital allocation allows companies to invest their surplus funds to maximize profits and improve shareholder equity. Reinvesting their capital in business operations or other ventures helps them expand and gain a foothold in the market.

Moreover, this supports positive value creation, allowing firms to gain competitive advantage.

How Agicap can help monitor capital allocated?

Agicap is an intuitive cash flow management software that centralizes your business’s cash flow and automates tedious tasks so that you can focus on running it. You can analyze the cash inflow and outflow through a centralized dashboard. Moreover, this solution allows you to speed up collections to reduce payment delays.