Question

On which three factors does a firm's investment decision depend? Discuss.

Short answer

The three factors that influence a firm's investment decisions are: 1. Expected rate of return on the investment: Companies evaluate the potential profitability of an investment project compared to other alternative investment opportunities and choose the investment that offers the highest expected return, considering the associated risks. 2. Cost of capital or the interest rate: Companies will evaluate the cost of capital against the expected rate of return and invest in projects if the return exceeds the cost of capital. A lower cost of capital makes an investment project more attractive. 3. Business risk: Companies assess the different risks, such as market risk, credit risk, and operational risk, when making investment decisions. They will prefer investing in projects with lower risk levels, considering the possible return on investment. These factors contribute significantly to a firm's investment decision-making process, allowing them to make informed and profitable choices.

Step-by-step solution

Identify the three factors affecting investment decisions

The factors that influence a firm's decision to invest in a project can be classified into three main categories: 1. Expected rate of return on the investment. 2. Cost of capital or the interest rate. 3. Business risk.

Discuss how the expected rate of return affects investment decisions

The expected rate of return is an important factor to consider when making investment decisions. This refers to the amount of profit or gain an investor expects to receive after a specific period in percentage. A higher expected return generally signifies a more attractive investment. Companies evaluate the potential profitability of an investment project compared to other alternative investment opportunities. They will choose the investment that offers the highest expected return, considering the associated risks.

Explain the role of the cost of capital in investment decisions

The cost of capital, or interest rate, is another essential factor to take into account when making investment decisions. It represents the cost of obtaining funds to finance the investment project. This can include the cost of debt or equity financing. A lower cost of capital makes an investment project more attractive because it implies lower financing costs. Companies will evaluate the cost of capital against the expected rate of return and will invest in projects if the return exceeds the cost of capital.

Discuss the effect of business risk on investment decisions

Business risk refers to the uncertainty associated with the future earnings and potential losses that a company might face due to various external and internal factors. High business risk implies a high chance of losses, which may lead to unfavorable outcomes for the investment project. Companies assess the different risks, such as market risk, credit risk, and operational risk, when making investment decisions. They will prefer investing in projects with lower risk levels, considering the possible return on investment. These three factors - expected rate of return, cost of capital, and business risk - play significant roles in a firm's investment decision-making process. Firms will carefully consider each of these factors to make informed and profitable investment choices.