How to Manage Capital Allocations
How do you compare different potential investments? Every investment has an opportunity cost — the loss of the next best option — so corporations really need to ensure that they’re picking the best option, and that includes, potentially, no capital investment at all.
Calculate the equivalent annual cost
Probably the best place to start is by calculating the equivalent annual cost of each potential investment. You calculate this as follows:
EAC = NPV/[1 – (1 + Discount rate)-n]
Basically, this equation allows you to compare the annual costs of potential investments with differing duration periods and cash flows in an apples-to-apples approach.
The real test of whether any of the potential investments are being successful or not will depend greatly on the ability of the corporation to derive value from the project, however. Just because it now has the capacity to create something, doesn’t mean it can create the demand or make it work. To figure that out, you need to incorporate a calculation for capital efficiency:
CE = Output/Expenditures
Once you have an idea of the amount of actual output being generated by an actual project, you can understand a few additional bits of information.
First of all, you can determine the amount of cash flows at a given rate of efficiency, and the degree to which that efficiency must increase in order to increase the NPV of the project. The percentage of deviation between current performance value and planned NPV is equivalent to the amount of increased efficiency that the corporation must derive from the investment.
Next, the estimate at completion (EAC) is then used to determine which one of several potential investments is going to generate the greatest returns for the corporation. Thanks to the equivalency of the analysis, whichever option has the highest EAC is the best one. Go with it.
Unless, of course, they’re all either low or even negative. If they’re all negative, you’ll lose money on all of them and you shouldn’t invest in any of the options. If they’re all low enough that you’d be better off putting those investments into some sort of financial investment or bank account, then it’s probably best to go with that option.
The next logical topic of discussion is liquid asset management. This is a very frequent analysis of whether it’s better to allocate resources toward liquid assets with low returns but low risk or long-term assets, which usually have higher returns but higher risk. Of course, as noted, if your long-term potential assets have low returns, then why take on the additional risk? Just go with the liquid investments.
Consider liquid assets
Allocating resources and assets into capital investments is about more than just long-term assets. Although long-term assets tend to get the most attention because of their high cost and higher risk, liquid assets must also be evaluated for their performance and returns.
Whether you put money into a long-term asset or a liquid account will be determined, in large part, by the amount of liquidity risk the corporation is facing as well as its estimated future cash flows.
All corporations, of course, want to generate the highest rate of returns that they can from every single penny they own. Of course, this is impossible given the timing of their costs and expenditures, so they need to maintain a type of extremely short-term liquid assets: economic capital.
Basically, economic capital is all the money that’s kept in banks, cash, or anything else that can be immediately liquidated to pay for daily cash requirements.
Any money kept in economic capital is money that isn’t put into investments. Therefore, carefully assessing liquidity risk, cash requirements, and future cash flows is an important part of efficiently utilizing your assets to generate returns. You may be awfully tempted to invest more money than is operationally wise into investments in order to maximize the rate of returns, but that’s a temptation you must avoid.
The other form of liquid asset you need to consider for the purposes of this chapter is called inventory. Inventory includes all the assets that are going to be sales; including finished products, work-in-process, and raw materials. These very liquid assets not only keep a corporation from investing, but also cost money to keep in storage.
That’s why many corporations are now paying very careful attention to and innovating in the field of inventory management. The ultimate goal is JIT inventory management; JIT stands for just-in-time.
To provide some perspective on what this means, the following list contains some descriptions of the progression of production. Each phase has its own costs and valuations; JIT works to reduce the costs associated with each step as much as possible, ensuring that the final outlet for the sale receives their inventory just as they run out (ideally, in very small quantities delivered frequently).
Finished products: These are products that are ready to be sold. They’re completely finished, and storing them until they’re bought costs money. Direct sales tend to be cheaper because the costs of storage and distribution are lower without retailers, particularly for made-to-order products.
Work-in-process: These are products that have been started but aren’t yet complete. Decreasing the amount of time in-process can cut costs and increase rates of return.
Raw materials: These are materials that haven’t yet begun to be processed. The majority of inventory management is focused here, ensuring that materials don’t arrive before they’re really needed.
The cost of inventory comes primarily from storage. Just like any other capital investment, the increased expenditures required for space to store and maintain inventory, known as the cost of inventory, can reduce the rate of returns generated by selling this form of inventory as capital.
JIT attempts to manage the supply chain by ensuring that inventory in its various forms arrives immediately when it’s needed but not a moment sooner. This strategy ensures that inventory remains available while reducing the costs associated with inventory.
By applying NPV to inventory management, you can see that JIT can dramatically increase the rate of returns on capital. By shortening the duration of capital in inventory, the NPV of inventory increases almost instantly. The results are twofold:
Corporations can generate returns on the money that otherwise would have been allocated to inventory in the meantime.
Corporations can reduce the opportunity costs associated with short-term liquid assets.