Uses of Capital

Overview

To achieve profitability and reach sustainability, a company must use its resources effectively and make long-term investments that increase revenues and profits. Investment opportunities returning long-term benefits and future cash flows greater than their associated cost to fund generate value for companies and corresponding wealth for their owners. Decisions on where and when to make long-term capital investments are, therefore, key management decisions central to a company’s operating success and longevity. Understanding how companies allocate their capital among competing priorities and their resulting portfolios of investment activity is a fundamental area of knowledge for financial analysts for many reasons.

The allocation and investment of capital are important corporate activities. Capital investments (also referred to here as capital projects) are investments with a life of one year or longer, and they make up the long-term asset portion of the balance sheet. They can be so large that sound capital allocation decisions ultimately decide the future success of many corporations. Capital investments also describe a company’s future prospects better than its working capital or capital structure, which are intangible and often similar for companies. Analysts may attempt to estimate the process, within reason, for companies that are not too complex and, in doing so, better evaluate corporate decisions that extend to financing and other related activity. Analysts may also be able to appraise the quality of the company’s capital allocation process—for example, on the basis of whether the company has an accounting focus or an economic focus. In doing so, analysts derive insights into how the company is creating value for investors.

This reading is organized as follows: Section 2 presents the steps taken by companies in a typical capital allocation process and the basic principles of capital allocation. In Section 3, we introduce basic investment decision criteria, and in Section 4, we discuss capital allocation options—known as real options—that allow their holders, in this case companies, to make decisions in the future that alter the value of their capital investment decisions made today.  Section 5 covers a discussion of the common capital allocation pitfalls often made by companies, and a summary concludes the reading.

The member should be able to:

• describe the capital allocation process and basic principles of capital allocation;
• demonstrate the use of net present value (NPV) and internal rate of return (IRR) in allocating capital and describe the advantages and disadvantages of each method;
• describe expected relations among a company’s investments, company value, and share price;
• describe types of real options relevant to capital investment;
• describe common capital allocation pitfalls.