Do Firms Really Allocate Capital So Inefficiently?

Abstract

The capital allocation process is a fundamental, organizational capability that drives value creation. The bulk of extant empirical research, as well as evidence from prominent field studies, concludes that the capital allocation process is a significant capability weakness: managers appear to make consistently inefficient capital allocation decisions. This paper asks whether managers are truly allocating capital so inefficiently, or can a more robust measure of allocation efficiency demonstrate that the capital allocation process is instead a capability strength. In the first stage of the empirical analysis, managers are found to be allocating capital more than twice as efficiently than prior literature suggests. The second stage validates the new measure by demonstrating that managers are capable of enhancing performance through strategic capital allocation.