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Strategic Corporate Finance: Applications in Valuation and Capital Structure by Justin Pettit

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OPTIMAL CAPITAL ALLOCATION

An optimal allocation of capital considers and balances the competing needs and objectives of all stakeholders within the enduring value maximization objective. Analysts, investors, and other stakeholders will all seek to determine whether the company has appropriately considered and balanced their needs to support its strategy. The existing capital structure must be evaluated to determine the appropriate prioritization and scaling of needs, including operating liquidity, dry powder, pensions and leverage, dividends, and share buybacks.

Operating Liquidity

As discussed, a certain level of cash work-in-process (WIP) buffer is required to fill the system and provide adequate operating liquidity, normal course funding self-sufficiency to ensure continued operations without undue risk of financial distress. Operating liquidity needs are increased by higher operating volatility, lower expected operating cash flows, and higher fixed costs, including dividends and debt servicing.

Dry Powder

With valuations predicated on profitable growth, growth capital represents the use of cash with the greatest potential upside for many companies. Dry powder can provide backup liquidity for event risk. However, prefunding growth opportunities by holding excess cash creates a drag on ROCE, economic profit, and NPV; that is likely to worsen as rates rise and cash balances grow. Furthermore, though operating liquidity needs may be estimated with cash flow simulation analysis, ...

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