By University of Phoenix
Companies make decisions daily about how to use resources and assets in their business operations and growth plans. These decisions aim to increase equity for owners and shareholders in publicly traded companies. However, decisions about capital allocation are more complex than trying to increase share price or dividend payments. Decision-makers also need to weigh risks, the economic climate and other factors when developing strategies on where to invest a company’s profits.
Understanding how to allocate capital best and develop effective strategies is important for helping improve an organization’s financial performance. Let’s dive into the role capital allocation plays in business and how employees can apply it in the workplace.
According to Gartner, capital allocation is “the process of determining the most efficient investment strategy for an organization’s financial resources, with the goal of maximizing shareholder equity.” In other words, it involves choosing how to deploy financial assets and other resources to maximize profits.
The strategies behind allocating capital cover a wide range of business activities, such as investing in research and development, increasing dividends for shareholders and purchasing smaller companies or assets.
Capital allocation is often used interchangeably with capital investments. However, allocation typically focuses more on how to use financial resources, while investment is the asset or development project funded by allocation.
In simplest terms, when a company reinvests its capital, it can expand its business operations. New products, services, acquisitions or assets spur growth. This expansion can increase profits and, more importantly for the CEO, bring more value to the company. Value is what ultimately drives share prices upward and increases equity, which is the sum of money that shareholders would receive if the organization liquidated its assets and paid its debts.
Many variables are at play in allocating resources. If an executive decides to put money into one area, it will get tied up there, making it impossible to use if a better opportunity arises elsewhere.
We can see a prime example of this method within the automotive industry. A major vehicle brand decided to invest in hydrogen-powered cars instead of electric vehicles, which ultimately put it behind its competitors.
Executives rely on different approaches to inform their capital allocation decisions. They may:
Economic data or industry forecasts can also play a role in capital allocation decisions.
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Since allocating capital can take various forms, most companies don’t simply rely on a single allocation method. It’s essential to understand the different options for capital allocation if you plan to embark on a business career.
Here are five allocation strategies:
1. Organic growth
2. Mergers and acquisitions
3. Debt payments
4. Dividend payments
5. Shares buyback
Here’s a closer look at each method.
Companies invest in organic growth by putting more resources into research and development for a new product or increasing the size of their production or operations. Organic growth is an effort to increase current sales or activity using in-house resources.
An executive can limit risk with organic growth by focusing on activities and departments already performing well. These slow and steady steps are attractive to CEOs who want to limit risk.
However, other methods, such as mergers, offer much quicker growth potential. In a competitive industry, you need more focus on organic growth to stay toe-to-toe with your rivals.
Here are some examples of organic growth:
Mergers and acquisitions are methods for increasing the value of a company in the short term. Mergers are when two comparable companies combine their resources and employees and become a new company.
Acquisitions, on the other hand, are much more common. This type of capital investment occurs when a larger company purchases a smaller one and absorbs it into its operations. A company might acquire another to expand into new industries or areas immediately without going through a development process.
The primary advantages of mergers and acquisitions are that they lead to immediate growth, expansion into new markets and quick results. However, valuation can be challenging, meaning that the acquisition or merger might not lead to the desired spike in shareholder equity.
Companies often take on debt to expand operations or get through slow economic times. When it earns profits, a company can pay off these loans. This will improve the debt-to-equity ratio, which is an important indicator of overall company health.
On the negative side, paying debts does not directly improve growth prospects. Depending on the type of loan or bond and interest rate, restructuring the debt may be better than paying it off and forgoing other capital allocation methods.
Dividends are company profits paid to shareholders. Executives and the board of directors can set the dividend amount, increasing or decreasing it depending on the value of each share of the company.
Shareholders will often reinvest in the company using dividend profits, which can increase share price further. Investors see dividend-paying stocks as more stable than other stocks, so they are more likely to reinvest.
Some experts argue that organic growth or mergers will bring more long-term advantages because these methods give a company a better chance to increase the share price with new assets and activities.
Share buybacks are when the company purchases stock from investors. This method returns cash to investors and also has tax benefits.
This method is low risk because it keeps equity in the company. Also, unlike dividends, the company gets something in return for its cash payment to investors. Companies then have stocks in hand, which they can sell again to raise more capital. In this way, their finances remain liquid.
Share buybacks are not without controversy. Buybacks may boost executives’ compensation packages, meaning they may be motivated by personal reasons instead of what’s best for the company.
A profitable company will likely use more than one of the five strategies described. Ideally, executives will consider specific criteria when deciding where to place their resources.
For example, a company in the manufacturing industry may combine several methods to determine the ideal allocation of resources. It may look something like this:
Even though there is plenty to gain in capital allocation, there are challenges to be aware of.
Even though capital allocation may seem like it involves risky gambles, companies can also veer toward the opposite side of the spectrum — risking stagnation by not making serious allocation decisions. This is just one of the risks and pitfalls executives encounter when trying to decide on the best use of resources. Here are some other things to be aware of:
Implementing allocation strategies requires a broad range of knowledge. Understanding all aspects of business affected by capital allocation can give decision-makers the best chance of making the right choice. For this reason, aspiring business professionals may want to consider pursuing a degree program that helps provide an educational foundation to develop these plans within an organization.
Capital investment strategies are covered in several business programs and courses at University of Phoenix, although to different degrees. The following are programs in which you can take at least one course where you can learn more about capital investment strategies:
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