The Capital Allocation Process | CFA Level I Corporate Issuers

In this lesson, we shall learn its uses, the steps in the capital allocation process, and the categories of capital allocation projects.

What is Capital Allocation?

Capital allocation is the process of identifying and evaluating capital projects, which are projects where the cash flow will be received over a period longer than a year. Any corporate decisions with an impact on future earnings can be examined using this framework. This can be decisions on whether to acquire a new asset, to replace an existing asset, to expand the business to other markets, or even to restructure the company, just to name a few. As some of these decisions can be quite costly and determine the future success of the firm, capital allocation is often viewed as one of the essential skills you need to have as a financial manager.

Besides, the principles underlying the capital allocation process also apply to other corporate decisions, such as working capital management and making strategic mergers and acquisitions. Finally, making good capital allocation decisions is consistent with management’s primary goal of maximizing shareholder value.

Steps in the Capital Allocation Process

The capital allocation process can be summarized into 4 key steps:

1. Generate good project ideas: Such ideas can come from anywhere, from the top (pause), to the bottom of the organization, from any department or functional area, or from outside the company.
2. Analyse the individual proposals: This step involves gathering the information to forecast cash flows and profitability for each project.
3. Create a firm-wide capital budget: Firms must prioritize profitable proposals according to the timing of their cash flows, available company resources, and the company’s overall strategy. This last point is important as some projects may make financial sense, but may not make sense strategically for the company. It is at this stage that firms decide on which projects to embark on, and which projects to drop or leave for future consideration.
4. Monitor the projects and conduct a post-audit: In a post-audit, actual results are compared to planned or predicted results, and any differences must be explained. This is important as it helps to identify systematic errors in the forecasting process. It also helps improve business operations. If sales or costs are out of line, it will focus attention on bringing performance closer to expectations. Finally, monitoring and post-auditing will produce concrete ideas for future investments. Managers can decide to invest more heavily in profitable areas and scale down or cancel investments in areas that are disappointing.

Categories of Capital Allocation Projects

So, what kind of projects are suitable for the capital allocation process? There can be a wide range of projects, and they may be classified into the following categories:

• Non-discretionary replacement projects: To keep the business running, these are normally made without detailed analysis. This is because there is little uncertainty with the decision. For example, if a machine that is required to continue production is damaged, the company should just replace it quickly without much deliberation so that production can continue.
• Discretionary replacement projects: If the replacement involves discretionary replacement of existing equipment with newer, more efficient equipment, there can be some uncertainty with the decision. A fairly detailed analysis may be necessary to determine if it can result in long-term cost savings.
• Expansion projects: These are taken on to grow the business and are likely to involve more uncertainties than replacement decisions. A very detailed analysis is usually required.
• New product or market development: This can expose the company to even more uncertainties than expansion projects. These decisions are more complex and will require an even more detailed analysis.
• Mandatory projects: These may be required by a governmental agency or insurance company and typically involve safety-related or environmental concerns. Although these projects typically generate little to no revenue, the company will accept the required investment in order to continue to operate.
• Other projects: These are projects that are not easily analyzed through the capital allocation process. Such projects may include a pet project of senior management, or a high-risk R&D project that is difficult to analyze with typical capital allocation assessment methods.

And that concludes this introductory lesson on capital allocation. We shall learn some of the basic principles of capital allocation in the next lesson.