Principles of Capital Allocation

Capital Allocation Principles

Although the known analytical tools and investment decision criteria are quantitative and clear-cut, there is significant room for errors and misjudgments. To enhance the decision-making process, it is essential to adhere to certain fundamental capital allocation principles when employing these tools. They include:

• Focus on additional cash flows with a broad perspective: It’s essential to consider only the extra cash flows generated by an investment while also taking into account their wider impact on the company. This means excluding any expenses that have already been incurred, known as sunk costs, but including both positive and negative effects on other parts of the business.
• Importance of cash flow timing: The timing, duration, variability, and potential changes in the direction of expected cash flows are critical factors to consider. These aspects can significantly influence the net present value (NPV) and internal rate of return (IRR) of a capital investment.
• Consideration of after-tax cash flows: When making capital allocation decisions, it’s important to analyze cash flows on an after-tax basis. This approach ensures that the tax implications, including benefits from non-cash deductions like depreciation, are properly accounted for in the analysis.

Capital Allocation Pitfalls

Some of the common capital allocation pitfalls or mistakes are:

Cognitive errors in capital allocation

1. Internal Forecasting Errors: Companies may make internal forecasting errors that are hard, if not impossible, for external analysts to spot. Consequently, this might lead to unsuccessful investment results. A common one is using a company’s overall cost of capital rather than an investment’s required rate of return.
2. Ignoring costs of internal financing: Cash flows from operations are the primary financing source for investments by large corporate issuers. Management treats internally generated funds as scarce but accessible, and the funds are allocated according to the budget. External financing is only used to fund large transactions such as acquisitions. The management’s viewpoint is flawed because internally generated capital is equity financing since it would be returned to equity investors as dividends. While a share issue does not raise it, the funds are withheld from equity investors, incurring their opportunity costs.
3. Inconsistent treatment of or ignoring inflation: In several ways, capital allocation is affected by inflation. It should be stated if investment analysis uses real or nominal terms. Companies are at liberty to perform analysis in real or nominal terms, but they should use a consistent approach for cash flows, and discount rates should be used.

Behavioral biases in capital allocation

1. Inertia: By comparing the current capital investment to the amount from the previous year and the return on investment, analysts can determine the presence of inertia. An analyst should evaluate an issuer’s justification for its capital investment. Further, they should consider if the management should contemplate alternate uses if capital spending each year is either stagnant or rising despite declining returns on investment.
2. Basing Investment Decisions on EPS, Net Income, or ROE: Even for those with a high NPV, many investments do not increase earnings per share (EPS), net income, or return on equity (ROE) in the short run. Since managers often have short-term incentives, they may choose projects not aligning with the company’s long-term interests.
3. Pushing Pet Projects: These are projects that influential managers want the company to invest in even though they may not be profitable. Often, managers exaggerate these projects’ profitability to ensure they are selected.
4. Failing to Consider Investment Alternatives or Alternative States: The most basic phase in the capital allocation process is the generation of solid investment ideas. In some organizations, however, many good alternatives are never even explored. Furthermore, many businesses overlook real-world conditions, which should be considered through breakeven, scenario, and simulation analyses.

Question

Which of the following statements is most likely accurate?

1. In capital allocation, only pre-tax cash flows should be considered.
2. The timing of cash flows is crucial to the capital allocation process.
3. A non-conventional cash flow pattern has an initial cash outflow followed by a series of cash inflows.

The correct answer is B.

Capital allocation analysts make an extraordinary effort to detail precisely when cash flows occur.

A is incorrect. Cash flows are analyzed after tax; taxes must be fully reflected in capital allocation decisions.

C is incorrect. A conventional cash flow pattern (not a non-conventional cash flow pattern) has an initial cash outflow followed by a series of cash inflows.