Capital Allocation – Different Questions
RISKVIEWS has been confused by the vehemence of some people about the topic of capital allocation.
Some people feel that capital MUST be allocated to facilitate proper management.
Other feel that capital MUST NEVER be allocated because it leads to incorrect decisions.
But RISKVIEWS suspect that they may be talking about two different questions.
Those who think that they MUST allocate capital are trying to answer the question “How DID we do?”
Those who think that they MUST NEVER allocate capital are focused on the question “What SHOULD we do?”
Of course, the two questions often get mixed up. But one is about the past and the other one is about the future. The problem that folks who object to capital allocation are afraid of is that if capital is allocated for the purposes of answering the “How DID we do?” question, then the same sort of allocation will be used to answer the “What SHOULD we do?” question.
And that IS a problem. The “What SHOULD we do?” question needs to be answered with projections of the future. Many decisions that are worth worrying about do not settle within a single year, so the projections need to be multi year.
But the problem that they are worried about is the problem of making a multi year decision with a single year projection. Whether capital is allocated or not, that is a poor way to go.
Multi year decisions need multi year projections. The multi year capital impact needs to be included. That can be done with a cost of capital factor or be a carefully constructed model that reflects capital inflows and outflows and then implicitly charges a cost for capital held. The multi year calculation usually needs to be discounted at an appropriate risk adjusted discount rate.
RISKVIEWS rule of thumb for selecting a discount rate is that all risks should be included ONCE and only ONCE in the entire calculation. So if the calculation is a stochastic one that includes scenarios that reflect the possible adverse effects of a risk, then the discount rate should not also include a charge for that risk. If your projection includes ALL possible risks, then a risk free rate is an appropriate discount. Remember that the market charges a risk premium for its perception of emerging risks. And for the risk of strategic failure.
So RISKVIEWS concludes that there is no harm from allocating capital. There is a harm from making multi year decisions with a one year projection. Whether or not capital is allocated. And multi year decisions need to include the effect of capital usage.