discussion

Do you agree or disagree with any of the concepts in post below? Why an investment decision like this is not always as straightforward as it might seem. Provide information or concepts that may not have been considered.

The phrase ‘too good to be true’ is oft times applied in business. Take for instance a situation where a financial manager has an opportunity to earn a rate of return on an investment that is greater than the cost of capital. Many would say this manager would be a fool if they passed on that opportunity. However, most investment decisions are not as cut and dry as they may appear. Financial managers need to take into consideration many factors to ensure they are making the correct decision.  For instance, the investment could have a large amount of hidden risk associated. It is likely that the manager used the CAPM equations to show the rate of return. That equation is fraught with assumptions that could invalidate its results. Chief among them is using a risk-free rate. It is not a guarantee that the company would qualify for the necessary rate in a real, moving, and volatile market.

Additionally, the manager should also consider the company’s personal affinity for risk. If the company’s financial position is tenuous it is highly unlikely that they should take on additional debt, which would skew their debt to equity ratio. This mix of debt to equity ratio is important because it pinpoints the optimal capital structure where the debt benefits the company more than it costs (Ross et al., 2020). The management style of the company’s executive team is also a factor in this equation. If they are conservative it is likely they would choose equity value over acquiring additional debt whereas a more aggressive team might push to increase profits through more risky investments. The manager should also account for the working capital requirement of the firm. Working capital is the difference between the firm’s assets and liabilities (Investor Trading Academy, 2016). If the firm has a shortage or shortfall of capital it would require immediate resources instead of the long-term promise of the investment. Moreover, the state of the market is a huge factor the manager must consider. In a depressed economy the manager could find it difficult to acquire the capital necessary to make the investment. Each of these factors are critical and should be given due consideration prior to a decision being made.