How Do You Win the Capital Allocation Game?

Which is better for your firm? Invest prodigious amounts of capital or scale back on capital investment? Reduce employment to raise the dollar amount of assets at work per employee or elevate employment to meet the demands created by new investments? Questions like these confront all senior managers as they formulate strategic plans and allocate capital. The questions become more compelling as investors demand that corporations consistently deliver shareholder value regardless of their long-term strategy for deploying human and financial capital.

An important factor that distinguishes the winners from the losers in creating shareholder value is the quality of investment decisions, which, in turn, depends on the soundness of a firm’s capital budgeting system. Unfortunately, the history of corporate America is littered with examples of poor investment decisions, ranging from investing too little in positive NPV (net present value) projects and too much in negative NPV projects to investment myopia.1 Such distortions can distract companies from what they do best, causing them to sink millions of dollars in the wrong products and ideas. For instance, Coca-Cola invested in pastas and wines, products for which its rates of return were not only well below those of its core soft-drinks business, but also below its cost of capital. Such errors deplete shareholder value and lead to corporate control contests that result in CEO replacements and hostile takeovers.

Despite the obvious consequences of misallocating capital and human resources, why do companies continue to blunder? We believe it is because they have flawed capital budgeting systems, which they apparently fail to recognize. Some firms sense the weaknesses in their capital budgeting analyses but view them as individual problems rather than systemic deficiencies. They misdirect efforts to redress mistakes and produce greater frustration. As a result, corporate strategy and capital allocation become misaligned and remain so despite disappointing financial performance. Senior management then gets the blame for failing to provide the appropriate leadership and strategic guidance.

Our goal is to present a framework that senior managers can use to allocate capital. The framework explicitly recognizes that capital budgeting cannot be the exclusive domain of financial analysts and accountants but is a multifunctional task that must be integrated with a firm’s overall strategy. Our capital budgeting framework has six key features, each indispensable (see

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References

1. See W. Fruhan, “Pyrrhic Victories in Fights for Market Share,” Havard Business Review, volume 50, September–October 1972, pp. 100–107; and

A.V. Thakor, “Investment ‘Myopia’ and the Internal Organization of Capital Allocation Decisions,” Journal of Law, Economics and Organization, volume 6, Spring 1990, pp. 129–154.

2. See L. Trigeorgis, Real Options (Cambridge, Massachusetts: MIT Press, 1996); and

A.K. Dixit and R.S. Pindyck, “The Options Approach to Capital Investment,” Harvard Business Review, volume 73, May–June 1995, pp. 105–118.

3.See, for example:

R.F. Mager, What Every Manager Should Know about Training (Belmont, California: Lake Publishing, 1992).

4. For interesting research on this issue, see:

L. Trigeorgis, “The Nature of Option Interactions and the Valuation of Investment with Multiple Real Options,” Journal of Financial and Quantitative Analysis, volume 28, number 1, 1993, pp. 1–20.

5. In firms with large amounts of debt following leveraged buyouts, it is typical to tie compensation to cash flows because a key objective is to generate cash flows to pay off the debt.

6. EVA is defined as [return on net assets - weighted average cost of capital] × net assets. Thus the present value of all future EVAs for a project equals its NPV.

7. See A.M. Brandenburg and B.J. Nalebuff, “The Right Game: Use Game Theory to Shape Strategy,” Harvard Business Review, volume 73, July–August 1995, pp. 57–73; and

F.W. Barnett, “Making Game Theory Work in Practice,” Wall Street Journal, 13 February 1995.

8. N.A. Nichols, “Scientific Management at Merck: An Interview with CFO Judy Lewent,” Harvard Business Review, volume 72, January–February 1994, pp. 88–99.

9. One way to evaluate both types of risks is with Monte Carlo simulation. Analysts can forecast input ranges (or probability distributions) for a project’s key value drivers (e.g., units sold, price, costs, and so on) instead of assigning a single expected value. These values determine the project’s yearly free cash flows (FCFs), which are then discounted at the cost of capital to arrive at the project’s NPV. A simulation then draws from these input distributions, resulting in a distribution of yearly FCFs and NPVs. The analyst now has the expected NPV and the likelihood that the NPV is positive, given the underlying assumptions. All else equal, the firm should accept all projects with positive expected NPVs. However, in light of capital constraints, corporate strategy, and project interactions, the distribution of NPVs may be very important in making key decisions.

Simulation analysis is also useful for calculating the expected yearly FCFs when there are interdependencies across different variables or options latent in the project. For example, price and unit demand may be negatively correlated or there may be an abandonment option. Often, the analytical solution to these relationships is difficult to obtain, thereby making the simulation analysis useful in calculating the numerical solution to these problems.

10. In one company, we observed analysts in one region who consistently assumed that the assets invested in new products had no residual value after ten years, whereas analysts in another region would assume that the residual value was the present value of a perpetual stream of the net operating profits after tax in the tenth year. Both regions competed for the same capital pool. Guess which region received larger capital allocations?

11. This issue was raised by:

P. Barwise, P.R. Marsh, and R. Wensley, “Must Finance and Strategy Clash?,” Harvard Business Review, volume 67, September–October 1989, pp. 85–90.

12. For a discussion of other consequences of draconian expense cutting, see:

B. Wysocki, Jr., “Some Companies Cut Cost Too Far, Suffer ‘Corporate Anorexia,’” Wall Street Journal, 5 July 1995.

13. Another benefit of consistently having short cycle times is that the firm becomes quite adept at responding quickly to change, which may result in a lowered operating risk for the project, thereby offsetting some of the information risk. There may also be learning benefits (learning by doing) associated with short cycle times.

14. It is important to note that while a firm’s strategy will dictate where the firm should be in terms of cycle time and risk for different types of projects, the option valuation method for risk reduction will enable the firm to focus its capital allocation on projects that are consistent with that strategy.

15. See, for example:

J. Martin, “Ignore Your Customer,” Fortune, 1 May 1995, pp. 121–126.

Acknowledgments

We would like to thank Dick Brealey, Sarah Cliffe, and two anonymous referees for very helpful comments. Any errors are solely our own.