Case Study: Maximizing Capital Investment Using Strategic Value

Mohammed Alqady

Pyrovio Consulting

1. Introduction
   Organizations in today’s economy, despite usually having a long wish list of projects or initiatives to execute, operate with limited capital funds. Under these conditions, effectively allocating capital becomes vital for a firm’s future success. This study proposes a novel approach to capital allocation that focuses on maximizing the value of capital investment for the organization. A case study from the electric utility industry is presented and a comparative analysis is used to quantify the benefits of the proposed approach, compared to the regular ad-hoc approach for capital allocation.

2. Electric utilities – Challenges to efficient capital allocation
   Electric utilities deal with a number of internal and external challenges that, in the absence of a structured approach to capital allocation, may easily impact the decision-making process and lead to sub-optimal investments. Examples of such challenges include:

• Minimal consensus on what ‘value’ means and how it can be quantified
• Limited funds to execute everything required
• Uncontrollable risks and the resulting risk mitigation plans
• An unstable, volatile portfolio of projects; a long-term project plan that consistently changes
• Regulatory requirements dictating project selection
• A perception of what makes a project ‘mandatory’
• Separation between budgeting and strategic planning functions in the organization
• Missing information and inconsistent data across multiple systems required to make decisions
  

Facing these challenges, companies may take reactionary decisions, instead of implementing a systemic capital planning process, which will lead to limited value and wasted money. Moreover, in a regulated environment where transparency and justification of decisions is critical, ad-hoc decision making is no longer acceptable. To address these challenges and avoid reactionary decisions, we suggest a structured, proactive approach that aligns capital investment with strategic priorities and objectives. This ensures that capital allocation decisions are made with the primary objective of maximizing strategic value.

3. Optimizing Capital Allocation
   Capital allocation is the process of deciding on how to invest the capital budget of a company to improve its efficiency and increase its profits. Accordingly, capital allocation can be viewed as an optimization problem presented by Equation 1, where:

X is a possible portfolio from a comprehensive set of possible portfolios (A)

F(x) is the objective function that represents the strategic value of a specific portfolio

X0 is the optimum solution or the portfolio that maximizes value
𝑓(𝑥0) ≥ 𝑓(𝑥) 𝑓𝑜𝑟 𝑎𝑙𝑙 𝑥 ∈ 𝐴

To better illustrate this, assume a project list of three projects A, B, and C. Table 1 quantifies the projects
in terms of cost and strategic value. Also assume that the available capital budget is $75M and that the
projects are treated equally (i.e., no specific requirements whether regulatory or other favors a project
over the other). Under these conditions, optimum capital allocation is the selection of a portfolio of
projects that will return the largest strategic value.

Table 2 details the comprehensive list of possible portfolios, including the remaining budget amount, or
the money left on the table if a specific portfolio was selected. Three portfolios highlighted in gray (#4,
5, and 6) are automatically eliminated because they exceed the annual budget. Of the remaining ones,
portfolio 6 provides the highest strategic value and least remaining budget, thereby utilizing the
available budget to the fullest while maximizing the strategic value. Note that in this example, the
optimum portfolio does not include the project with the highest individual strategic value (project A).

The proposed approach was validated on the case study detailed below. For this implementation, the
Allovance Methodology1 was used to determine the strategic value of projects. The Allovance
Methodology uses a systemic approach to define and quantify an organization’s strategic priorities and
objectives. All projects are then scored based on the resulting strategic value scorecard and project
selections for the final portfolio can be made based on strategic value, complexity, and urgency. This
way, strategic alignment guides the capital allocation process.

4. Case Study
   A. Problem Statement:
   The objective of the case study was to demonstrate the efficiencies achieved from using a capital allocation approach that maximizes strategic value. The organization operates in the electric utility field. The master project list consists of 250 projects, with a total value of $208M. Due to external factors outside the control of the organization, the available funding was reduced by 15% (i.e., a revised funding amount of $177M). The following scenarios were evaluated, and a comparative analysis was conducted for the resulting portfolios:

Scenario 1: The organization’s current method of selecting projects to include/exclude from the
portfolio

Scenario 2: maximizing strategic value when developing the organization’s portfolio using
Allovance

In addition to the budget constraint due to the reduction, a large number of projects are considered
mandatory projects; they must be selected in any final portfolio, regardless of their strategic value. Of
the 250 projects on the project list, 112 were mandatory with a total value of $164M. Accordingly, the
objective of the optimization is to determine the project set that maximizes the strategic value of the
selected portfolio within the constraints of budget and mandatory requirements, i.e. fill out the
discretionary space highlighted in Figure 1 with projects that result in the maximum strategic value
portfolio.

B. Results & Discussion
Two portfolios were compared, the Selected Portfolio resulting from Scenario 1, and the Optimized
Portfolio resulting from Scenario 2. From a dollar perspective, both scenarios by design will result in
portfolios that fit the required constraints (budget and mandatory requirements). The total strategic
value of both scenarios reveals the difference between them. Figure 2 shows that for the same
discretionary amount left after the budget reduction, the optimum portfolio included projects that have
twice the strategic value as the selected portfolio. Given that the original project list had a total strategic
value of 10,576 points, the cost of the budget reduction from a strategic standpoint for Scenario 1 was a
loss of 44% of the original strategic value, while for Scenario 2 the cost was only 34%.

In the above analysis, strategic value points of equal budget portfolios are compared. While this what-if
scenario analysis is practical for capital allocation decision making, it is hard to understand the
difference relying on strategic value points. In order to make this more salient, the following analysis
was performed to quantify the difference using dollars.

The Selected Portfolio’s strategic value (5,886 points) was used as a target, and the Optimized Portfolio
was adjusted by eliminating projects until a portfolio with a strategic value equivalent to the target was
created. This Equivalent Portfolio represents the projects from the Optimized Portfolio that can achieve
the same strategic value points of the Selected Portfolio. By comparing the costs of the Equivalent and
Selected Portfolios, the losses incurred from not optimizing capital allocation can be quantified in
dollars. Figure 3 illustrates this comparison.

Taking into consideration the constraint created by the mandatory projects and by optimizing, the target
strategic value of 5,886 points can be achieved with projects that cost $2M, compared to $13M with the
Selected Portfolio. In other words, the Equivalent Portfolio offers the same strategic value at a 6%
discount to the adjusted budget. The $11M difference is therefore money wasted by not optimizing
capital allocation.

C. Note on Mandatory Projects
A reasonable observation on the results may suggest that a 34% reduction in strategic value is not
proportionate to a reduction of only 15% to the original budget. At face value that may seem true, but
what that observation fails to consider is the significant impact of the mandatory project constraint on
the optimization results. In essence, although the original budget was $208M, only $44M was
discretionary and the rest was held up by mandatory projects. With the revised budget, the 15%
reduction ($31M in value) was absorbed completely by the discretionary budget; the mandatory
projects had to proceed in all cases. In effect, the reduction was equivalent to a 70% reduction to the
discretionary fund. Under these conditions, maintaining 66% of the original portfolio’s strategic value is
impressive.
As can be seen by the results of the analysis, mandatory projects have a significant impact on the total
strategic value of the portfolio. It is recommended that organizations employ a well-defined criteria for
mandatory projects and be very strict in implementing it otherwise mandatory projects can severely
limit the number of viable potential portfolios to choose from. Also, having mandatory projects that
align with the organization’s strategic priorities and objectives is always a bonus when trying to
maximize strategic value in capital allocation.

5. Conclusion
   A good capital planning solution should:

With limited funds and increasing scrutiny on how funding is used, it is becoming crucial for organizations to present clear, transparent, and justifiable reasons for their capital allocation decisions. In this paper, we argue that the basis of this justification should b the organization’s strategy; projects that help achieve strategic priorities and objectives should be prioritized and selected for funding. Under these conditions, we propose an optimization approach for capital allocation with an objective function of maximizing strategic value under known constraints such as budget and portfolio requirements. The benefits of the approach were highlighted in an actual case study. The proposed approach guarantees maximizing the value of the resulting portfolio from a strategic perspective in a transparent and justifiable framework.