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Cash Flow Management Best Practice

Allocating Corporate Capital Fairly

by John L. Mariotti

Table of contents

Executive Summary

  • The principal job of management is the allocation of scarce resources—people, time, and money—to opportunities that yield the greatest returns.

  • There is always a shortage of capital and an excess of worthy projects. There are many methods of capital allocation, but most do not fund the best opportunities.

  • The key task is to allocate capital to support the greatest opportunities, those that match strategic objectives.

Introduction

The appetite of organizations for capital is insatiable. Understanding the nature of capital and its effective allocation is essential to organizational success. Classical economics defines land, labor, and capital as the determinants of wealth, each being exclusive to its owner. Now there is a fourth determinant of wealth—information—and it is nonexclusive. The more information is shared, the more valuable it becomes. Business is a competition in which the score is kept in money, and thus allocation of capital, in all its forms, is a critical success factor.

The challenge is to decide which division, project, or acquisition gets the scarce capital. The challenge varies with the source of capital. Venture capitalists’ and hedge funds’ tolerance for risk is offset by their high return expectations. The low risk of municipal bonds and banks is matched by low returns. Hedge funds make increasingly larger “bets,” while equity investors carefully consider exit strategies in capital allocation decisions. Privately owned companies strive to enhance shareholder value, matching investment choices to their investors’ expectations. Public companies are servants of the public stock markets and investment analysts. Each master has different expectations, and thus capital allocation must vary accordingly.

Allocating Capital

If capital is allocated foolishly, or to poorly defined projects, it is wasted. The game is a simple one: invest the least possible amount, borrow the rest, and put it in projects with the greatest potential return (or occasionally the lowest risk). Deciding which ventures to invest in has always occupied management attention. There are many quantitative methods for allocating capital. Most of these remain valid, but they share one problem: they all depend on a forecast of future events, which is uncertain. The challenge is to allocate capital to the best opportunities, given the risk-reward profile of the investors, and to choose projects that have the best chance of earning good returns.

The Typical Plan: Allocation for Strategic Purposes and Objectives

Capital allocation must be aligned with the strategic purposes and objectives of the investor. The implication is that these are well defined and clearly understood. However, this is frequently not the case. Often the strategies and goals are unclear or poorly understood.

The Typical Practice: An Artifact—The Capital Budget

Organizations develop capital expenditure budget needs for annual review by boards and lenders. A common breakdown of a capital budget is by category or type of expenditure—for example, new products, new facilities, maintenance of existing products or facilities, and infrastructure needs. This is a theoretically sound method since each category has a different strategic purpose: for example, sustaining current activities or revenue streams, creating new revenue streams, or providing infrastructure to support current or new business needs. These category splits are intended to allow senior management and boards to allocate capital fairly according to the company’s strategic needs. The problem is that there is an enormous gap developing those artifacts of bygone eras—capital budgets—and the actual intent of the investments. This traditional route is a sure path to sustained mediocrity or steady decline.

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Further reading

Books:

  • Drucker, Peter F. Management Challenges for the 21st Century. New York: HarperBusiness, 1999.
  • Hamel, Gary. Leading the Revolution. Cambridge, MA: Harvard Business School Press, 2000.
  • Hamel, Gary, and C. K. Prahalad. Competing for the Future. Boston, MA: McGraw-Hill, 1996.
  • Selden, Larry, and Geoffrey Colvin. Angel Customers & Demon Customers. New York: Portfolio, 2003.

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