Risk-Return Trade-Off
Most financial decisions comprise alternative courses of action. The choices have different returns and risk. As like example, must we buy a replacement machine currently or must we wait till next year, must we set the debt-to-assets ratio at 20%, 40% or any another ratio?
The higher the risk on any conclusion, the higher the needed return to compensate for this risk. The relationship between Risk and Return can be expressed follows as:
Required Rate of Return = Risk-free rate + Risk premium.
Risk free rate is compensation for risk premium and time is return for risk of financial actions. It can be seen such the relationship is direct.
The finance manager should ignore decisions along with unnecessary risk. In creating financing decisions as example, the finance manager must decide whether to finance with equity alone or to use debt as well. The expected return when debt is required is high as the cost of debt is low. Although, since payment of interest on debt is compulsory, so the risk comprises is high. At the other hand the cost of equity is high and thus the return is low. The risk is also low while payment of ordinary dividend is not compulsory. The firm's liquidity decisions will also affect the risk and the return of such firm.