What Is Capital Allocation?
Capital allocation is about where and how a corporation's chief executive officer (CEO) chooses to spend the money that the company has earned. Capital allocation means distributing and investing a company's financial resources in manners that will increase its efficiency, and boost its profits.
A firm's management seeks to dispense its capital in manners that will create however much wealth as could be expected for its shareholders. Dispensing capital is muddled, and a company's prosperity or disappointment frequently pivots upon a CEO's capital-allocation choices. Management must think about the reasonability of the accessible investment options, assess every one's possible effects on the firm, and distribute the extra funds suitably and in a way that will create the best overall outcomes for the firm.
Grasping Capital Allocation
Greater-than-anticipated profits and positive cash flows, but attractive, frequently present a bind for a CEO, as there might be a great numerous investment options to gauge. A few options for designating capital could incorporate returning cash to shareholders by means of dividends, repurchasing shares of stock, giving a special dividend, or expanding a research and development (R&D) budget. On the other hand, the company might opt to invest in growth drives, which could incorporate acquisitions and natural growth consumptions.
In the ways a CEO chooses to dispense the capital, the overall goal is to boost shareholders' equity (SE), and the test generally lies in figuring out which allocations will yield the main benefits.
Instances of Capital Allocation
Nobel prizewinners Franco Modigliani and Merton Miller distinguished return on investment (ROI) as a huge supporter of shareholder value. A company might increase ROI by making improvements to profitability and deciding to wisely invest its funds. To measure how well the company transforms capital into profit, one would take a gander at the return on invested capital (ROIC).
Newell Brands Inc. (NASDAQ: NWL) held its first-quarter earnings call with investors in April 2016. Fourteen days sooner, the company had completed its merger with Jarden in a stock and cash deal valued at more than $15 billion. On the call, Newell's management illustrated its capital-allocation needs, which included continuing to pay dividends, trailed by repaying debt. Management's goal was to accomplish its targeted leverage ratio inside a few years. When they achieved this target, the management wanted to invest in growth drives.
In December 2015, Neil Williams, former chief financial officer (CFO) at Intuit Inc. (NASDAQ: INTU), underscored the significance of a trained capital-allocation approach for the company. This approach included overseeing internal spending like R&D, investing in acquisitions, and returning money to shareholders. Williams likewise disclosed that Intuit's benchmark return as 15% more than a five-year period.