Investment Choices (Introduction to Economics) - Practice Question [Solution]

Ware Digital system, is working on its new project ‘Criminal Record Lockup’. This project is expected to give return Rs.308, 5000 during the year. However, company is in discussion with its bank regarding the financing of this project. The bank has informed the company that loan will carry 5% annual interest rate. Company total invested capital for this project will be Rs. 56, 000, 000. Risk index of the project is 4%.



a. Should Ware Digital system accept this project? Why?

Answer:

Return on Capital = Return Invested capital *100

                                     = 3085000/56000000*100 = 5.51%

Cost of Capital     = 5%                                         

The return on capital is greater than the cost of capital, so Ware Digital system should accept this project.

b. If Ware Digital system were traditionally risk-averse? Would they make this investment? Why? What if they were risk-seeking?

Answer:

Investors deal with risk by choosing the amount of risk they are willing to incur-that is, they decide their risk tolerance. Some investors choose to incur high levels of risk with the expectation of high levels of return (risk taker/risk seeker). Other investors are unwilling to assume much risk and they should not typically expect to earn large returns. (Risk averse). For making investment decision, investors decide on their risk tolerance-how much risk they are willing to assume when investing, so they need to think in terms of the expected return-risk trade-off that results from the direct relationship between the risk and the expected return of an investment.

• If Ware Digital system were traditionally risk averse, they will not assume more risk unless they expect to be compensated. Here risk index is 4% and return is 5.5%. They will accept this project because expected return is large enough to compensate for assuming risk. On the other hand, If Ware Digital system were risk seeker then they wish to try to earn a larger rate of return, they must be willing to assume larger risk as compensated by moving up the expected return. So, preferably, they will not go for this project as return (5.5%) is not satisfactory. Based on the basic element of all investment decisions, the greater (smaller) the expected return, the greater (smaller) the risk.