Capital Allocation

Capital Allocation Decisions

Consolidated financial statements can hide the individual characteristics of dissimilar subsidiaries. As a result, firms are required to disaggregate financial information by segments to assist users.

Recall that a business segment is a portion of a larger company that accounts for more than 10% of the company’s revenues or assets, and is distinguishable from the company’s other line(s) of business in terms of risk and return characteristics. Geographic segments are also identified based on the same criteria.

Although required disclosure under U.S. GAAP and IFRS is limited, the disclosures are valuable in identifying each segment’s contribution to revenue and profit, the relationship between capital expenditures and rates of return, and which segments should be de emphasized or eliminated.

Continuing our example, Thunderbird operates four different divisions: aircraft, automotive, marine, and specialty products. Figure 12.8 presents Thunderbird’s revenue and EBIT by segment.

Figure 12.8: Revenue and EBIT by Segment

Figure 12.8 reveals that in terms of contributing revenue and EBIT, the automotive division is the largest segment while the specialty products division is the smallest. Also, the percentage contribution to EBIT by the specialty products division declined from 5.8% in 2021 to 5.1% in 2023.

Thunderbird’s assets and capital expenditures by segment are presented in Figure 12.9.

Figure 12.9: Assets and Capital Expenditures by Segment

Not surprisingly, Figure 12.9 reveals that the automotive division requires the greatest proportion of assets and capital expenditures. Note that the specialty products division has the least assets of all four divisions and that the aircraft division has required the least capital expenditures. Also note that the capital expenditures of the specialty products division have increased over the period.

Using the percentages from Figure 12.9, we can calculate the ratio of proportional capital expenditures to proportional assets for each segment. A ratio greater than one indicates the firm is growing the segment by allocating a greater percentage of its capital expenditures to a segment than that segment’s proportion of total assets. Conversely, a ratio of less than one indicates the firm is allocating a smaller percentage of its capital expenditures to a segment than its proportion of total assets.

If these trends continue, the segments will represent a more or less significant proportion of the firm over time.

By comparing the EBIT margin contributed by each segment to its ratio of capital expenditure proportion to asset proportion, we can determine if the firm is investing its capital in its most profitable segments.

Figure 12.10: EBIT Margin and CapEx % to Assets % by Segment

From Figure 12.10, we note that while the specialty products division has, by far, the lowest EBIT margin, it has the highest capital expenditures proportion to assets proportion ratio. Additionally, the specialty products division’s EBIT margin is declining. If Thunderbird continues to overallocate capital resources to the specialty products division, the firm’s company wide returns may suffer.

Accrual based measures such as EBIT may not be a good indicator of an entity’s ability to generate cash flow. We would rather evaluate segmental capital allocation decisions based on cash flows generated by each segment. However, segmental cash flow data is generally not reported.

We can, however, approximate cash flow as EBIT plus depreciation and amortization. Figure 12.11 provides depreciation and amortization expense by segment. Figure 12.12 shows the cash flow estimates using segmental EBIT from Figure 12.8 and segmental depreciation and amortization information from Figure 12.11.

Figure 12.11: Depreciation and Amortization Expense by Segment

Figure 12.12: Estimated Cash Flow = EBIT + Depreciation/Amortization

We then compute cash operating return on average total assets using information from Figure 12.12 and computing average total assets for 2022 and 2023 from information in Figure 12.9. Figure 12.13 shows the relevant information including EBIT margins from Figure 12.10.

Figure 12.13: Segmental Cash Generation and EBIT Margins

Average assets are calculated as beginning assets + ending assets divided by

2. Using data from Figure 12.9, the 2023 average assets for the aircraft division is ($14,777 + $6,861)/2 or $10,819. Hence, for 2023, the cash flow to average assets for the aircraft division is $2,612 / $10,819 = 24.1%. Figure 12.13 confirms poor capital allocation decision to the specialty products division.

In addition, we can see that the aircraft division, while continuing to produce superior operating margins, has fallen behind in cash generation in the latest year.