Capital Allocation – Value Creator or Distructor

Published by Sharekhan Education | January 30, 2021

Capital Allocation – Value Creator or Distructor 

Capital allocation is how a company decides to distribute its financial resources. It is extremely important in the success of a company. The main goals of capital allocation are to ensure the business’s ongoing health and optimize long-term value creation. Investment decisions are crucial for both short-term and long-term performance.

Capital is primarily allocated for:

Maintenance Expenses:

This is the first area where capital will be allocated for ensuring that all machinery, buildings, and workplaces are in order and are not in dire need of repair. These expenses are urgent, and cannot be delayed.

Debt Reduction:

After paying down maintenance expenses, the firm may decide to pay down more of the companies’ debt. This decision is more complicated for executives because they have to evaluate the trade-off between investing the money into assets that yield higher returns against the higher profits that it would generate by paying off debt and lowering interest costs.

Organic Growth:

Companies also reinvest their profits into internal growth projects such as capacity addition, research, the launch of new products, etc. Most of the free cash flow in a younger company will likely be reinvested to grow the company. A young company growing at a fast pace can try and acquire more market share with its growth strategies. Acquisitions can be riskier than internal investments, and most businesses will only acquire other companies that complement the company’s existing line of business.

Buyback/Dividend:

A dividend is that part of the profit which companies distribute directly to the shareholders. Firms do this when they feel like they have excess cash sitting on the balance sheet which cannot be put to more productive use. By buying back shares, the company would indirectly reward the shareholders as the buyback reduces the number of shares and increases the earnings per share leading to a higher share price at the same valuation multiple. However, there are several cautionary pointers that one needs to keep in mind before deciding whether the buyback would turn out to be value accretive or not.

Inorganic Growth:

Mergers & Acquisition are an inorganic way of growing and bringing synergistic benefits to the firm. This is another way a company could choose to spend a vast amount of free capital. Acquisitions can be riskier than internal investments, and most businesses will only acquire other companies that complement the company’s existing line of business.
Where companies decide to employ their capital makes a huge difference in the returns they will generate for investors. Good capital allocation will enable the company to grow profits and maximize shareholder returns. Good capital allocation is the key to compounding shareholder wealth.

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