What is Capital Allocation
Capital allocation is a system of distributing financial resources to various sectors to increase efficiency and thereby maximize profits. Overall, it is management's goal to optimize capital allocation so that it generates as much wealth as possible for its shareholders. Allocating capital is a complicated process. There may be numerous options to consider that require the evaluation of each viable and its effects on the overall company.
Capital Allocation: My Favorite Financial Term
BREAKING DOWN Capital Allocation
When companies realize higher than expected profits, management is tasked to allocate the additional funds appropriately and in a manner that will produce the best outcome. Such options could include issuing a special dividend or increasing the research and development (R&D) budget. While the goal is to maximize shareholders equity, the challenge lies in determining the allocation of money to each action that will yield the most significant benefit.
While generating positive cash flow is a satisfactory development, it presents a challenge to management, who will have to decide how to invest the funds best. Options include returning cash to shareholders via dividends and repurchasing shares of stock. The company may opt to invest in growth initiatives. These initiatives include acquisitions and organic growth expenditures. Organic growth can involve purchasing new equipment or expanding into a new geographic market or product line.
Capital Allocation Examples
Nobel prizewinners Franco Modigliani and Merton Miller identified the return on investment (ROI) as a significant contributor to shareholder value. To measure how well the company turns capital into profit, one would look at the return on capital (investment). A company may increase ROI by making improvements to profitability and choosing prudent investments of its funds.
Newell Brands Inc. held its first-quarter earnings call with investors on April 29, 2016. The company 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, which included continuing to pay dividends followed by repaying debt. Management's goal was to achieve its targeted leverage ratio within two to three years. Following the accomplishment of their primary targets, management planned to invest in growth initiatives.
In December 2015, Neil Williams, the chief financial officer (CFO) at Intuit Inc., emphasized the importance of a disciplined capital allocation approach for the company. This approach 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.