A capital allocation decision rule for knowledge-intensive organizations

Abstract

We formulate a mathematical programming problem for allocating capital budget between the organizational and physical capitals of the firm and solve it to obtain an analytically tractable and easy to implement decision rule for the optimal allocation of the capital budget. The model we develop depicts interconnections of these capitals and their constituent variables in the context of the firm's valuation through the growth of its operating income. Finally, we illustrate our findings through the optimal capital allocations by the largest software companies using data from their financial statements over the period 1991– 2015. We find that managers of software companies that allocate more of their capital budget to organizational capital on a steady basis enjoy superior financial performance.