5 methods of capital allocation
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.
1. Invest in organic growth
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:
- Investing in an existing product: If your company has a successful product in market, you can invest in equipment, facilities and employees to increase production. Increasing the supply could lead to greater profits as long as demand holds steady.
- Increase marketing: You can also try to reach more customers by increasing existing marketing efforts or developing new campaign strategies to raise awareness of your brand or product.
2. Mergers and acquisitions
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.
3. Pay off debt
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.