Capital Allocation: Definition & Overview

KEY TAKEAWAYS

• Capital allocation is the process of allocating funds to different investments.
• Companies use many different methods to allocate their capital. These include return on investment (ROI), net present value (NPV), and payback period.
• Capital allocation is a critical part of a company’s management. It can have a major impact on the company’s profitability and growth.

What is Capital Allocation?

Capital allocation is the process of allocating capital, or financial resources, to investments. The goal of capital allocation is to create a portfolio that meets the investor’s goals and risk tolerance.

There are many ways to allocate capital. But the two most common are strategic asset allocation and tactical asset allocation. Strategic asset allocation is a long-term approach. This investment strategy involves allocating capital to different asset classes.

They’re based on the investor’s goals, time horizon, and risk tolerance. Tactical asset allocation is a short-term approach. It involves making adjustments to the portfolio based on market conditions.

Which approach is best depends on the individual investor. Some investors prefer the stability of a strategic asset allocation. Others like the flexibility of a tactical asset allocation. The best approach is the one that meets the investor’s goals and objectives.

When it comes to capital allocation, there are a few things to keep in mind. First, asset allocation is not static. The mix of assets in the portfolio should be regularly reviewed and rebalanced as needed.

Second, don’t put all your eggs in one basket. Diversification is key to mitigating risk. And finally, remember that capital allocation is just one part of investment decisions. Other important considerations include security selection, portfolio construction, and risk management.

Following these guidelines can ensure that your capital gets allocated in a way that meets your objectives.

How important is capital allocation?

The allocation of capital is important because it allows businesses to secure the funding they need to grow. And once funding is secured, owners can commence with their capital allocation decisions.

The capital allocation process also gives investors a stake in the company. And it provides them with a degree of control over its operations. However, there are some risks associated with capital commitments.

If the company or venture fails to meet its financial obligations, the investor may be liable for the losses. Additionally, if the company or venture gets sold or goes public, the investor may not receive any investment return.

If the return on investment seems minimal, it might be best to rethink your strategy. Ideally, you want assurance of long-term growth. A high-return investment that doesn’t reflect internal growth initiatives won’t likely pay off.

The capital allocation road isn’t always straightforward. But you do want to be able to turn capital into profit. An ideal capital structure will ensure a glorious capital upside. 

Capital allocation tools are helpful to both investors and companies or ventures. But it’s important to carefully consider the risks and benefits before entering into a contract. What are they? Keep reading to find out.

Process of Capital Allocation

The process of capital allocation typically begins when a company or venture raises money from investors. The company then uses this money to finance its operations and growth.

As the company grows, it may need to raise additional funds from investors. This is through either debt or equity financing. Debt financing involves the company borrowing money from lenders and then repaying the loans with interest. Equity financing involves the sale of shares in the company to investors.

Shares can sell either through an initial public offering (IPO) or a private placement.

Once the company has raised the necessary funds, it can then begin to allocate its capital. This involves deciding how to best use the money to grow the business.

There are a number of factors that the company will need to consider when making this decision. ie., the company’s financial goals, the current market price, and the risks associated with each investment.

The company will also need to decide how much money to raise from each type of investor. For example, it may decide to raise more money from equity investors if it is seeking a higher level of growth.

Alternatively, it may choose to raise more money from debt investors if it is looking for a lower level of risk.

Once the company has determined how much money it needs to raise, it can then begin seeking out investors. This is through a number of channels, such as private placement or an IPO.

The company will then negotiate the terms of the investment with the investors. This will include deciding on the amount of money raised, the type of security issued, and the interest rate paid.

Once the terms have been agreed upon, the company can then begin to allocate its capital. This may involve investing in new products, expanding into new markets, or hiring new employees.

The company will continue to raise capital as needed in order to finance its growth. As it does so, it will need to re-evaluate its capital allocation strategy on a regular basis. This will ensure that it is using its resources in the most efficient way possible.

Types of Capital Allocation

There are a few different types of capital allocation. The most common include:

Mergers and Acquisitions

Mergers and acquisitions (M&A) is the process of combining two companies to form a new company. This type of capital allocation involves the use of financial resources, such as cash and debt, to finance the buying of another company.

Growth Equity

Growth equity is a type of investment that provides capital to a company in exchange for an ownership stake. This type of capital allocation is typically used to finance the growth of a company.

Capital Expenditures

A capital expenditure (CAPEX) is an amount spent to acquire or improve a long-term asset. This type of capital allocation is typically used to finance the purchase of property, plant, and equipment (PP&E).

R&D

Research and development (R&D) is the process of creating new products or services. This capital allocation often finances the costs of developing new products or services.

Strategic Investments

A strategic investment is one made by a company in another company or a lists of companies. It will help the first company achieve its goals. This type of capital allocation is often used to finance the purchase of a stake in another company.

Net Working Capital

Net working capital (NWC) is the difference between a company’s current assets and current liabilities. This type of capital allocation is typically used to finance the day-to-day operations of a business.

Diversification

By diversifying portfolios, investors mitigate some of the risks associated with investing. Investment advisers can help make sure investors get the best returns to shareholders. 

Risk Factors in Capital Allocation

There are a few risks that come with capital allocation. These include: 

• The risk that the company will not be able to raise the relevant funds.
• The risk that the company will not be able to use its capital in the most efficient way.
• The risk that the company will not be able to repay its debts.
• The risk that the company’s equity will be diluted if it raises money through an IPO.
• The risk that the terms of the investment will not be favorable to the company.

Capital Allocation – Example

Let’s say that Company XYZ is a small business that is looking to grow. In order to do so, it will need to raise some capital.

The company decides to raise $1 million through a combination of debt and equity financing. It sells $500,000 worth of shares to investors and borrows the other $500,000 from a bank.

The company then uses the $1 million to expand its operations. It opens new offices in different cities and hires new employees.

As the company grows, it will need to continue to raise capital in order to finance its growth. But it will also need to re-evaluate its capital allocation strategy on a regular basis. This will ensure that it is using its resources in the most efficient way possible.

Summary

Capital allocation is the process of allocating capital, or financial resources, to investments. The goal of capital allocation is to create a portfolio that meets the investor’s goals and risk tolerance. There are a number of different ways to allocate capital.

Which approach is best depends on the individual investor. Some long-term investors prefer the stability of a strategic asset allocation. Others like the flexibility of a tactical asset allocation. Ultimately, the best approach is the one that meets the investor’s goals and objectives.