Chapter One: Investments and Capital Allocation Framework

1.1. The investment Environment- An introduction

Today the investment environment is even more dynamic. World events can rapidly alter the
values of specific assets. There are so many assets from which to choose. The amount of
information available to investors is staggering and grows continually. Financial markets and
institutions are evolved in response to the desires, technologies, and regulatory constraints of the
investors in the economy. In fact, we would predict the general shape of the investment
environment (if not the design of particular securities). If we knew nothing more than these
desires, technologies and constraints. This chapter provides a broad overview of the investment
environment.
Investment environment can be defined as the existing investment vehicles in the market
available for investors and the places for transactions with these investment vehicles.
The main types of financial investment vehicles are:
• Short term investment vehicles;
• Fixed-income securities;
• Common stock;
• Speculative investment vehicles;
• Other investment tools.
Investment is a term for several closely related meanings in finance and economics.
Investment according to Theoretical Economics
Investment means the production of capital goods - goods which are not consumed but instead
used in future production.
Examples include, Building, a rail road, a Factory clearing land, putting oneself through college
Investment according to Finance Term
Investment means buying of Assets.
For example, buying stocks and bonds, investing in real estate and Mortgages
These investments may then provide a future income and increase in value (i.e., investing in real
estate).

Investment Management: Chapter One: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
Investment according to Oxford Dictionary
Investment means the investing of money.
Investment from an Individual Point of View
Investment refers to a money commitment of some sort. For example, a commitment of money
to buy a new car is certainly an “investment”.
“Investment Management is the process of managing money, including investments, budgeting,
banking and taxes, also called as money management.”
Investment management is the specialty area within finance dealing with the management of
individual or institutional funds. Other terms commonly used to describe this area of finance are
asset management, portfolio management, money management, and wealth management. In
industry jargon, an asset manager “runs money.”
Investment management involves five activities:
(1) Setting investment objectives,
(2) Establishing an investment policy,
(3) Selecting an investment strategy,
(4) Selecting the specific assets, and
(5) Measuring and evaluating investment performance.
1.2. Investment Activity
Investment activity includes buying and selling of financial assets, physical assets and
marketable assets in primary and secondary markets. Investment activity involves the use of
funds or savings for further creation of assets or acquisition of existing assets.
The material wealth of a society is determined ultimately by the productive capacity of its
economy—the goods and services that can be provided to its members. This productive capacity
is a function of the real assets of the economy: the land, buildings, knowledge, and machines
that are used to produce goods and the workers whose skills are necessary to use those resources.
Together, physical and “human” assets generate the entire spectrum of output produced and
consumed by the society.
In contrast to such real assets are financial assets such as stocks or bonds. These assets, per se,
do not represent a society’s wealth. Shares of stock are no more than sheets of paper or more
likely, computer entries, and do not directly contribute to the productive capacity of the
economy. Instead, financial assets contribute to the productive capacity of the economy

Investment Management: Chapter One: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
indirectly, because they allow for separation of the ownership and management of the firm and
facilitate the transfer of funds to enterprises with attractive investment opportunities. Financial
assets certainly contribute to the wealth of the individuals or firms holding them. This is because
financial assets are claims to the income generated by real assets or claims on income from the
government.
When the real assets used by a firm ultimately generate income, the income is allocated to
investors according to their ownership of the financial assets, or securities, issued by the firm.
Bondholders, for example, are entitled to a flow of income based on the interest rate and par
value of the bond. Equity holders or stockholders are entitled to any residual income after
bondholders and other creditors are paid. In this way the values of financial assets are derived
from and depend on the values of the underlying real assets of the firm.
Real assets produce goods and services, whereas financial assets define the allocation of income
or wealth among investors. Individuals can choose between consuming their current endowments
of wealth today and investing for the future. When they invest for the future, they may choose to
hold financial assets. The money a firm receives when it issues securities (sells them to
investors) is used to purchase real assets. Ultimately, then, the returns on a financial asset come
from the income produced by the real assets that are financed by the issuance of the security. In
this way, it is useful to view financial assets as the means by which individuals hold their claims
on real assets in well-developed economies.
Real and financial assets are distinguished operationally by the balance sheets of individuals and
firms in the economy. Whereas real assets appear only on the asset side of the balance sheet,
financial assets always appear on both sides of balance sheets. Your financial claim on a firm is
an asset, but the firm’s issuance of that claim is the firm’s liability. When we aggregate overall
balance sheets, financial assets will cancel out, leaving only the sum of real assets as the net
wealth of the aggregate economy.
Another way of distinguishing between financial and real assets is to note that financial assets
are created and destroyed in the ordinary course of doing business. For example, when a loan is
paid off, both the creditor’s claim (a financial asset) and the debtor’s obligation (a financial
liability) cease to exist. In contrast, real assets are destroyed only by accident or by wearing out
over time.

Investment Management: Chapter One: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
1.3. The Capital Allocation Framework
Capital allocation- A process of how businesses divide their financial resources and other
sources of capital to different processes, people and projects. Overall, it is management's goal
to optimize capital allocation so that it generates as much wealth as possible for its shareholders
or it is the process of deciding how to distribute an investor’s wealth among different countries
and asset classes for investment purposes. An asset class is comprised of securities that have
similar characteristics, attributes, and risk/return relationships.
The process behind making a capital allocation decision is complex, as management virtually has
an unlimited number of options to consider. For example, if a company ends up with a larger
than expected windfall at the end of the year, management needs to decide whether to use the
extra funds to buy back stock, issue a special dividend, purchase new equipment or increase the
research and development budget. In one way or another, each one of these actions will
likely benefit the shareholder, but the difficult part is in determining how much money should be
allocated to each action in order to yield the most benefit.

If you look at any organization today what you see is mainly the result of capital allocation
decisions made in the past. Its strategic assets, tangible or intangible, are traceable to the
investment decisions of yesteryears. Hence it is scarcely surprising that the key responsibility of
top management is concerned with capital allocation decisions. And this seems to be more so in
large divisionalised companies where a central concern of top management at the corporate head
office is to allocate capital across strategic business units and manage the investment decision
making activity in the entire group.
Capital is scarce and must be allocated across competing claims very judiciously. As Mike
Kaufman says “The selection of the investment projects and the allocation of corporate capital
to them are among top management’s primary responsibilities to shareholders. That means, a
good corporate investment program can mean sustained growth; failure to invest wisely can
hinder growth or threaten company survival.”
Capital budgeting is not the exclusive domain of financial analysts and accounts. Rather, it is a
multifunctional task linked to a firm’s overall strategy. As Richard Bower (USA) has said in his
perceptive work managing the resource allocation process that the set of problems firms refer to,
as capital budgeting is “a task for general management rather than financial specialist”.

Investment Management: Chapter One: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
The capital allocation framework of a firm spells out the kinds of business the firm wants to be in
the strategy of the firm, the types of investments that make sense for the firm, the approach of the
firm toward conglomerate diversification, so on and so forth.
It is divided in to six sections as follows:
 Key criteria
 Elementary investment options
 Portfolio planning models(Tools)
 Strategic position and action evaluation
 Diversification debate
 Strategic planning and capital budgeting
Key Criteria: the objective of maximizing the wealth of shareholders is reflected, at the
operational level, in three key criteria:
 Profitability
 Risk
 Growth
Profitability: it’s the principal driving force for business, reflects the relationship between
profit and investment. While there are numerous ways of measuring profitability, return on
equity is one of the most widely used.
Risk: the search for profitable activities almost invariably entails risk. It reflects variability:
How much do individual outcomes deviate from the expected value?
Growth: business firms actively pursue and achieve growth over a period of time. This is
reflected through the increase of revenues, assets, net worth, profits, and dividends and so on.
Elementary Investment Options/Corporate Resource Allocation Strategy of a Company
The corporate resource allocation strategy is the following elementary investments options:
 Replacement and Modernization
 Capacity expansion
 Vertical integration
 Diversification, and
 Divestment

Investment Management: Chapter One: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
Replacement and Modernization: Often regarded as an integral part of the “base level” capital
expenditure program meant to maintain as well as increase the production capability of the firm,
improves quality and reduce cost.
Capital Expansion: when a company anticipates growth in the market size of its product ranger
or an increase in the market share enjoyed by it in its product range, expansion of the capacity of
the existing product range would have great appeal. Such an expansion offers several
advantages:
- Familiarity with technology,
- Production methods and market conditions,
- Lower capital cost and reduction in overhead expenditure because of large volume of
production.
Vertical Integration: it may be two types:
 Back ward integration- which involves the manufacture of raw materials and
components required for existing operations of the company.
 Forward integration- involves the manufacture of products which use the existing
products of the company as input.
Diversification- involves entering a new business that is different from the current business.
There are two broad types of diversification:
 Concentric Diversification: involves getting into a related business. For example, a
detergent manufacturer may get into soap business; a truck manufacturer may go in for
passenger cars. Such diversification offers several advantages:
i. The company can leverage its core competencies and capabilities,
ii. Certain manufacturing facilities may be better utilized,
iii. All products may benefit from the market image of the company, and
iv. A common distribution network may be employed.
 Conglomerate Diversification: means that a firm gets into a new business which is
unrelated to its existing business line. For example, when an engineering company
invests in shipping it is a case of conglomerate diversification. The principal motivations
underlying conglomerate diversification are to:
i. Overcome the limited growth opportunities in the existing line of business,
ii. Enter newly emerging and promising sectors, and

Investment Management: Chapter One: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
 iii. Reduce the overall risk exposure of the firm.
Divestment: it is the opposite of investment. It involves termination/ liquidation of the plant or
even a division of a firm. From the seller’s perspective, it is a form of contraction; from the
buyer’s point of view, it is a form of expansion.
Motives: - To raise capital
- To bring about a desired strategic realignment
- To divest a unit earning a subnormal rate of return.
Portfolio Planning Models (Tools)
To guide the process of strategic planning and resource allocation, several portfolio planning
tools have been developed, two such tools, highly relevant in the context of our present
discussion are:
i. General Electric Portfolio Matrix
An approach for assessing projects within the wider strategic context which focuses on the
market attractiveness and business strength of the product and business unit relating to the capital
proposal.
The attractiveness of the market or industry is indicated by such factors as the size and growth of
the market, ease of entry, degree of competition and industry profitability for each strategic
business unit. Business strength is indicated by a firm’s market share and its growth rate, brand
loyalty, profitability, and technological and other comparative advantages. Such analysis leads to
three basic strategies:
1. Invest in and strengthen businesses operating in relatively attractive markets. This may
mean heavy expenditures on capital equipment, working capital, research and
development, brand development and training.
2. Where the market is somewhat less attractive and the business less competitive, the
business strategy is to get the maximum out of existing resources. The financial strategy
is therefore to maximize or maintain cash flows, while incurring capital expenditures
mainly of a replacement nature. Tight control over costs and management of working
capital leads to higher levels of profitability and cash flow.
3. The remaining businesses have little strategic quality and may, in the longer term, be run
down or divested unless action can be taken to improve their attractiveness.

Investment Management: Chapter One: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
 ii. Boston Consulting Group Approach
An approach for assessing capital proposals based on the market growth and market share of the
products relating to the proposal.
The Boston Consulting Group approach, which describes the business portfolio in terms of
relative market share and rate of growth. This matrix identifies four product markets within
which a firm may operate: (1) ‘stars’ (high market share, high market growth), (2) ‘cash cows’
(high market share, low market growth), (3) ‘question marks’ (low market share, high market
growth) and (4) ‘dogs’ (low market share, low market growth).
The normal progression starts with the potentially successful product (‘question mark’) and
moves in an anticlockwise direction, eventually to be withdrawn (divested).
Businesses offering high growth and the possibility of acquiring market dominance are the main
areas of investment (‘stars’ and ‘question marks’). Once such dominance is achieved, the growth
rate declines and investment is necessary only to maintain market share. These ‘cash cows’
become generators of funds for other growth areas. Business areas that have failed to achieve a
sizeable share of the market during their growth phase (‘dogs’) become candidates for
divestment and should be evaluated accordingly. Any cash so generated should be applied to
high-growth sectors.
Strategic Position and Action Evaluation (SPACE)
SPACE is an approach to hammer out an appropriate strategic posture/position for a firm and its
individual business. SPACE involves a consideration of four dimensions:
 Company’s competitive advantage
 Company’s financial strength
 Industry strength
 Environmental stability
The factors determining competitive advantage, financial strength, industry strength and
environmental stability are shown as follows:
Company’s Competitive Advantage Company’s Financial Strength
- Market share - Return on investment(RoI)
- Product quality - Leverage
- Product life cycle - Liquidity
- Product replacement cycle - Capital required

Investment Management: Chapter One: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
 - Customer locality - Capital available
- Competition’s capacity utilization - Cash flow
- Technological know-how - Ease of exit from market
- Vertical integration - Risk involved in the business
Industry Strength Environmental Stability
- Growth potential - Technological change
- Profit potential - Rate of inflation
- Financial stability - Demand variability
- Technological know-how - Price range of competing pdts
- Resource utilization - Barriers to entry in to market
- Capacity intensity - Competitive pressure
- Productivity, capacity utilization - Price elasticity of demand
Strategic Postures - The basic strategic postures associated with the space approach are as
follows:
 Aggressive Posture: this is appropriate for a company which (i) enjoys a competitive
advantage and considerable financial strength and (ii) belongs to an attractive industry
that operates in a relatively stable environment. An aggressive posture means that the
firm must fully exploit opportunities available to it, seriously look for acquisition
possibilities in its own or related industries, concentrate resources to maintain its
competitive edge, and enhance its market share.
 Competitive posture: this is suitable for a company which (i) enjoys a competitive
advantage but has limited financial strength, and (ii) belongs to an attractive industry
operating in relatively unstable environment. The key planks of this posture are; maintain
and enhance competitive advantage by product improvement and diversification, widen
the product line, improve marketing effectiveness, and augment financial resources.
 Conservative Posture: this is appropriate for a company which (i) enjoys financial
strength but has limited competitive advantage and (ii) belongs to a not- so- attractive
industry operating in relatively stable environment. A conservative posture calls for the
following actions: prune non- performing products, reduce costs, improve productivity,
develop new products, and access more profitable markets.

Investment Management: Chapter One: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
  Defensive Posture: this is suitable for a company which (i) lacks competitive advantage
as well as financial strength, and (ii) belongs to a not-so- attractive industry operating in
an unstable environment. Defensive posture involves the following actions:
- Discontinue unviable products,
- Control cost aggressively,
- Monitor cash flows strictly,
- Reduce capacity,
- Postpone or limit investment, i.e, eventually withdrawal or exit.
Strategic Planning and Capital Budgeting
Capital expenditures, particularly the major ones, are supposed to sub serve the strategy of the
firm. Hence, the relationship between strategic planning and capital budgeting must be properly
recognized.
Figure 1.1. Strategic planning and Capital budgeting

Environmental Managerial Vision, Corporate

Assessment Values, and Attitudes Appraisal

Strategic
Plan

Capital Product Strategy,

Budgeting Market Strategy,
Production Strategy and
so on

Investment Management: Chapter One: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.