Capital allocation

[ActPass]

It could be a bit late for the exam, but I'll have a go to see if any response:

In Assignment X6.8, it talks about capital allocation.

For "Allocate EC on a stand-alone basis", A=15m, B=33m, C=18m, total EC = 66m, while the company decides to hold 60m actual capital to retain the AAA rating.

The answer says "there is a benefit of 6m which can be held in the corporate line".

All are easy to understand. But what does it really mean though in practice? holding a negative 6m in the account or what?

 

[DevonMatthews]

It could be a bit late for the exam, but I'll have a go to see if any response:

In Assignment X6.8, it talks about capital allocation.

For "Allocate EC on a stand-alone basis", A=15m, B=33m, C=18m, total EC = 66m, while the company decides to hold 60m actual capital to retain the AAA rating.

The answer says "there is a benefit of 6m which can be held in the corporate line".

All are easy to understand. But what does it really mean though in practice? holding a negative 6m in the account or what?

what it means is that although you only need 60 million, your trying to protect the different business units from the quirks of different allocation methods.. so you allocate them all their stand alone capital (which totals 66 million) you can subtract all of it off the corporate line, rather than divide it up somehow between the business units and subtract off their share of the diversification benefit.

 

[ActPass]

Thanks for the response. However, I am still not 100% clear. Let me ask a slightly separate question: if the group is going to hold 60m capital in its account, where does it have 66m to allocate to business units A, B and C? Or is there something that I am missing here?

 

[DevonMatthews]

Thanks for the response. However, I am still not 100% clear. Let me ask a slightly separate question: if the group is going to hold 60m capital in its account, where does it have 66m to allocate to business units A, B and C? Or is there something that I am missing here?

We don'there ally have 66 million, were just looking at splitting the 60 million we do require between business lines. We allocate the stand alone capital for each line, but this totals to 66 million.. So under this approach we don't give any lines a diversification benefit.. We allocate the diversification benefit to the corporate line, and subtract 6m off its stand alone capital requirement that so everything sums to 60? I think this is what it means.

 

[David Wilmot]

It means that actual total EC is 6m less than the sum of the EC allocated to the various business units.

The ROCE for business units (calculated by reference to allocated capital) will be lower than if the diversification benefit (of 6m) was also allocated.