In this article we will discuss about the risk and return faced while financial planning of a company.
Costing and Risk:
The word ‘costing’ relates to the ascertainment of cost of capital from different sources like equity capital, preference capital, debentures, long-term loans etc. The most crucial decision of any company is involved in the formulation of its appropriate capital structure.
The best design or structure of the capital of a company obviously helps the management to achieve its ultimate objectives of minimizing overall cost of capital, maximizing profitability and also maximizing the value of the firm. These will in turn help to maximize the earning per share.
It is thus apparent that the design of the capital structure of a company may have some bearing on the profitability of that company. Capital structure decisions assume vital significance in corporate financial management due to their influence both on return and risk of the shareholders.
The close nexus between optimum/judicious use of debt and the market value of the firm is well recognized in literature. Whereas an excessive use of debt may endanger the very survival of the corporate firm, a conservative policy may deprive the corporate firm of its advantages in terms of magnifying the rate of return to its equity owners.
Risk-Return Trade off:
The prime objective of financial management is maximize the value of the firm, which is possible only when well-balanced financial decisions are taken. The management should try to maximize the average profit while minimizing the risk. The projects promising a high average profit are generally accompanied by high risk.
Managers should accept such projects only if they will induce an increase in stock price. It is known that ‘higher the return’, other things being equal, ‘higher the market value’ and vice versa. Hence, it should be kept in view that risk and return go together.
The risk-return trade-off is illustrated in figure 21.3.: