Capital Allocation
Capital allocation is generally an intermediate step in a decision-making process. Trying to determine which business units are most profitable relative to the risk they bear is a typical example.
Pricing these risks is another example of its use.
Focusing only on return on capital would lead one to allocate capital to each business unit, dividing the profits of each unit profits by the allocated capital. This approach would distinguish the marginally profitable units from the real value-adders.
There are several techniques available for capital allocation depending upon the priorities and profiles of an institution. While return on capital has been used for some time, people have also used market pricing based methodology, internal ratings of business approach, marginal approach, or business profitability criterion without risk considerations. While the general topic is capital allocation, this survey looks at methods for answering questions that capital allocation is addressing. To summarize, four basic approaches will be reviewed:
