capital-allocation

Capital allocation

Choosing among investments is choosing what not to do. This is the appraisal of individual

proposals; which businesses and bets the company should be in belongs to

corporate-strategy:portfolio-strategy.

Appraise on incremental cash

Only cash flows that change because of the decision belong in the analysis:

• Sunk costs are irrelevant. Money already spent is not a reason to continue, though it is

reliably presented as one.

• Allocated overhead is usually irrelevant. If the cost occurs anyway, it does not belong in the

incremental case.

• Opportunity cost is relevant, including the capacity consumed that then cannot serve anything

else.

• Working capital is a real outflow. Growth that consumes cash is not free because it is growth.

Discount for time and risk. A hurdle rate should reflect the risk of the specific proposal — applying

one company-wide rate systematically overfunds risky projects and starves safe ones.

Read payback for what it tells you

Payback ignores everything after the threshold and so is a poor ranking tool. It is a good *liquidity

and uncertainty* measure: how long capital is at risk, and how far into an uncertain future the case

depends on.

Use net present value to decide, payback to understand exposure. A proposal with strong NPV whose

returns all arrive in years four and five is a forecasting question as much as an investment one.

Interrogate the case, not the sponsor

Every proposal arrives advocated for. The useful questions are structural:

• What has to be true for this to work, and which of those is least certain?
• What is the counterfactual — what happens if we do nothing?
• Where is the optionality: can it be staged so a small commitment buys information before the large

one?

• Who is accountable for the benefit after approval?

Stage-gating dominates all-or-nothing commitment where uncertainty is high. Paying for information

first is usually cheaper than being right by luck.

Look back, or the numbers stay fictional

Compare realized outcomes against the approved case, and make it routine rather than punitive. Where

nobody looks back, forecasts drift optimistic because optimism is rewarded at approval and never

tested afterwards.

Sources

references/sources.md in this skill lists the outside authorities that settle the questions

here — what each one is authoritative for, and what you may do with it. Check them before

answering on anything they cover, and cite what you used. Most are free to read and not free

to reproduce; the use note on each is binding.

Never

• Include sunk cost in a forward case.
• Apply one hurdle rate to proposals of different risk.
• Rank by payback.
• Approve a benefit with no owner after approval.