Capital Allocation

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What is 'Capital Allocation'

Capital allocation describes how businesses divide their financial resources and other sources of capital to different processes, people and projects. Overall, it is management's goal to optimize capital allocation so that it generates as much wealth as possible for its shareholders. The process behind making a capital allocation decision is complex, as management virtually has an unlimited number of options to consider.

BREAKING DOWN 'Capital Allocation'

If a company ends up with a larger than expected windfall at the end of the year, management has various options for the cash. It could issue a special dividend, or it could increase the research and development (R&D) budget. While management and the board of directors intend to benefit the shareholder, the challenge is in determining how much money should be allocated to each action to yield the most benefit.

Investment Options

While generating positive cash flow is a satisfactory development, it presents a challenge to management, which will have to decide how to invest the funds. Options include returning cash to shareholders via dividends and repurchasing shares of stock. The company may wish to devote more finds to investing in growth initiatives, including acquisitions or organic growth, such as purchasing new equipment or expanding into a new geographic market or product line.

Creating Shareholder Value

Nobel prizewinners Franco Modigliani and Merton Miller identified return on investment (ROI) as a major contributor to shareholder value. The yardstick to measure return on capital against is the cost of capital.

There are two ways for a company to increase its return on capital: to improve its profitability by increasing revenue and/or reducing expenses, or to invest capital more prudently.

Examples

Newell Brands Inc. held its first-quarter earnings call with investors on April 29, 2016. The company had completed its merger with Jarden in a stock and cash deal valued at over $15 billion a couple of weeks earlier. In the call, Newell's management outlined its capital allocation priorities: continuing to pay dividends followed by repaying debt. Management's goal was to achieve its targeted leverage ratio within two to three years. Following this, management plans to invest in growth initiatives.

In December 2015, Neil Williams, chief financial officer (CFO) at Intuit Inc., emphasized the importance of a disciplined capital allocation approach for the company. This includes managing internal spending, such as R&D, investing in acquisitions and returning money to shareholders. The benchmark return for Intuit is 15% over a five-year period.

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