How Do You Win the Capital Allocation Game?

Why do companies frequently make bad investment decisions and continue to blunder, even after the weaknesses in their capital budgeting analyses are evident? Because, according to the authors, they don’t integrate capital budgeting into their overall strategy. Boquist et al. offer a capital budgeting framework that has six key features: (1) it is dynamic, (2) it is integral to the firm’s strategy, (3) it recognizes sequences of options, (4) it is cross-functional, (5) it aligns employee compensation with capital allocation, and (6) it emphasizes performance-based training.

The authors’ framework for dynamic capital budgeting has three simultaneous steps:

1. Identify a status quo strategy and how it must perform to maximize shareholder value. The strategy will help the company determine the trade-off in capital budgeting between cycle time and risk. The more time and resources it commits to collecting information about a project, the more it can learn about cash flows and the lower the risk. But it achieves this risk reduction at the expense of a longer cycle time.

2. Establish a system for evaluating projects and preparing capital allocation requests that is consistent with the strategy. The system has four phases — a new idea phase, preliminary evaluation phase, business evaluation phase, and go-ahead or reject phase — and three tollgates — strategic, preliminary, and business. For approval, a project must pass through all three tollgates.

3. Develop a culture consistent with the strategy and the evaluation system. The company’s long-term commitment to the strategy should be evident to employees. Employees from all functional areas should be trained in the system’s underpinnings. The employee compensation system should tie bonuses to performance measures that correlate with shareholder wealth.

Only by implementing an integrated framework, say the authors, can a company make intelligent investment decisions with long-term strategy in mind.