Additional Learning Material

CAPITAL ALLOCATION PROCESS

Good day students. I am Patricia Mogano, one of the lecturers in the UNISA’s Department of
Management Accounting.

Today we will be looking at the Capital allocation process. At the end of this recording, you
should be able to interpret the available methods of capital allocation (investment in organic
growth, pay down debt, mergers and acquisitions, pay dividends, and repurchase of shares)
for the organisation to inform decision-making, our learning outcome for this section.

1. Introduction

First and foremost, it is important to remember that the key objective of a business and
financial management is to maximise shareholders’ wealth. As already alluded in previous
lessons, this must be achieved within the parameters of business strategy, good governance,
and risk management amongst other things. We learnt in the lesson on Sources and forms of
finance that, Capital is the money used to support or finance long-term (non-current) assets
and projects. It is displayed as equity (owners’ interest) and long-term debt on the
statement of financial position. Capital allocation, therefore, refers to the strategy that a
business implements to distribute, re-distribute, and invest its capital (financial resources) to
maximise shareholders’ (stakeholders) wealth.

2. The following capital allocation methods will be briefly discussed:

o Organic growth investment

o Paying off business debts
o Mergers and Acquisitions
o Paying out dividends
o Repurchasing shares

2.1. Organic growth investment

This is the most common method businesses implement to allocate their capital. This method
involves the (re-)investment of capital into the business’s operations with the aim of generating
more revenue, profit margins and improvements in business processes, mainly in the long-
term. The method may be implemented in the form of introducing new products or services,
expanding into new markets, increasing operating capacity, investment in research and
development, etc. For instance, ESKOM, a state-owned company, may decide to invest in
renewable energy as part of its strategy to increase its electricity generation capacity.
 Additional Learning Material
CAPITAL ALLOCATION PROCESS

2.2. Paying off business debts

As discussed in the lesson on Sources and forms of finance, the Capital market is the main
source of capital and one of the main sources thereof is long-term debt. The providers of long-
term debt require the repayment of the capital amount borrowed and the related interest. The
repayment (term, rate, frequency, etc.) of the capital amount borrowed tends to be one of the
most key decisions for a business with excess capital. Because this decision typically impacts
the business’s gearing ratio and may also increase or reduce future payments of the related
interest. The benefit that may be derived from reduced interest expenses must be carefully
assessed considering the prevailing interest rates. i.e., the business may save on interest
expenditures in a high interest rate environment by paying off debts earlier (the opposite is
also true).

2.3. Mergers and Acquisitions

Another method businesses implement to allocate capital is through acquisition of/ merging
with competitors or customers in the same value chain. This method allows for opening new
revenue streams, accessing new markets as well as benefit from the existing capabilities of
the acquiree business. Some of the potential benefits associated with the implementation of
this method include, but not limited to, creating economies of scale, accessing better human
capital and information technology infrastructure, etc. For example, the Foschini Group may
to implement this method of capital allocation by acquiring Ackermans Stores.

2.4. Paying out dividends

You will remember from the Sources and forms of finance lesson that the Capital market is the
main source of capital and one of the main sources thereof is the equity market. The providers
of equity finance require a return on their investment in the form of capital growth and/or
payment of dividends. A business which pays dividends to its shareholders can be viewed as
shareholder friendly. The implementation of this method should be balanced-off with retaining
the funds for future investments, and thus the creation of long-term shareholder wealth, in the
form of capital growth of their investment. In days of excessive capital, the allocation of capital
to dividends payments can be considered.
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CAPITAL ALLOCATION PROCESS

2.5. Repurchasing shares

Lastly, another capital allocation method is that of buying-back (repurchasing) the issued
shares of the business. This method has the potential to increase the share price. The potential
increase in the share price has a direct influence on increasing the investment value for the
holders of remaining issued shares and this represents capital growth for shareholders. Other
potential advantages of repurchasing issued shares include, centralising shareholding control,
preventing hostile takeovers, and working towards the target capital structure.

3. Conclusion

In conclusion, at the end of this section we are expected to be able to interpret the available
methods of capital allocation for the organisation to inform decision-making. We learnt that
the implementation of capital allocation method(s) should be done while taking into
consideration long-term strategy, good governance, and risk management amongst other
things. This then allows for the potential to create long-term sustainable stakeholders’ wealth.
We then explored five capital allocation methods namely: organic growth investment, paying
off business debts, mergers and acquisitions, paying out dividends, and repurchasing shares.

This brings us to the end of our discussion on the capital allocation process.

References and additional reading:

https://cfohub.com/5-capital-allocation
strategies/#:~:text=What%20Is%20Capital%20Allocation%3F,the%20company's%20CEO%
20and%20CFO.

The Capital Allocation Process: Methods & Best Practices Every CFO Should Know
(embarkwithus.com)

Capital Allocation Explained | The 5 Methods Framework (suredividend.com)