Government securities

Government securities

Given that the encabulator market is risky, an 8% return on investment is considered an inferior return as compared to a 4% return on government securities. Government securities are risk-free and are therefore better than a risky, forecasted 8% return on investment. It is better to invest in a lower safe return of 4% than a projected 8% return which is subject to change, due to market trends and uncertainties, for example, the stock market in the U.S.A decreased to 38% in 2008 (Gu, 2016). Shareholders, who are the company investors, want to maximize the market value, and they would instead invest in lower risk-averse 4% rates than higher risk-seeker 8% forecasted rates.

The 4% rate of return on government assets is the company’s opportunity cost of capital. The CFO determines the cost of capital from observing the interest rates associated with risk-averse securities. The 4% of government securities returns are considered the actual company’s cost of capital because its assets have the same risk as to the government securities(Kaplan & Perez, 2020). However, for risky investments, the cost of capital has to be estimated. Moreover, financial markets are no longer a good gauge for determining the cost of capital, given the United States global recession.

The CFO is supposed to determine the opportunity cost of capital based on the forecasted rate on investment. For the company to maximize the shareholder’s value, the rates associated with new investment ventures should be higher than the company’s opportunity cost of capital. Otherwise, the investors will back away, sell their shares, then redeem their money to go and invest on their own (Intrisano et al., 2016). For example, in our case, the 8% projected rate on investment is higher than the company’s opportunity cost of 4%, meaning shareholders are maximizing their value.

References

Gu, L. (2016). Product market competition, R&D investment, and stock returns. Journal of Financial Economics, 119(2), 441-455.

Kaplan, Z., & Perez, Cavazos, G. (2020). Investment as the Opportunity Cost of Dividend Signaling. Available at SSRN 3393065.

Intrisano, C., Palomba, G., Micheli, A. P., & Calce, A. M. (2016). The relevance of financial structure in WACC’s determination. Research Journal of Finance and Accounting, 7(24), 173-187.