Investment Returns: Why Projects Need to Match Market Risk

Imagine you have some money saved up, and you’re considering two options for what to do with it. One option is to invest in a financial asset, like buying shares in a well-established company or purchasing a government bond. Let’s say these are relatively safe bets, like putting your money in a sturdy savings account, but with potentially better returns.

The other option is to invest in a project for your own firm. This could be anything from developing a new product line, expanding into a new market, or upgrading your company’s technology. These projects are often riskier than simply buying shares or bonds. They involve more uncertainty about whether they will be successful and generate the returns you hope for.

Now, think about it this way. If you can get a certain level of return by investing in a financial asset with a specific level of risk, why would you choose to invest in a company project with the same or higher risk if it offers a lower expected return? It wouldn’t make much sense, would it?

Let’s say you can invest in a bond that is considered quite safe and expected to give you a 5% return per year. This 5% return is your benchmark for that level of risk. If your company is considering a new project that is also considered to have a similar level of risk as that bond, then this project absolutely needs to promise an expected return of at least 5%, and ideally more.

Why? Because if the project only offered a 4% expected return, you would be better off just investing in the bond. You’d get a higher return for the same level of risk. It’s like choosing between two identical cars, but one is cheaper and gets better gas mileage – you’d always pick the better deal.

In the world of finance, we talk about opportunity cost. The opportunity cost of investing in a firm’s project is the return you could have earned by investing in a financial asset of comparable risk. If your project doesn’t at least match that return, you’re essentially losing out on potential gains. Your money could be working harder for you elsewhere, with a similar level of risk.

Think of it like this: if you’re a chef deciding what to cook for dinner. You have chicken and fish available. If both are equally easy to prepare and equally priced, but the fish tastes better, you’d naturally choose the fish. Similarly, if a financial asset and a company project have the same risk profile, but the financial asset offers a better return, then the financial asset is the more attractive ‘meal’ for your investment capital.

For a firm, using shareholder money to invest in projects that offer returns lower than what shareholders could achieve in the financial markets with similar risk would be detrimental to shareholder value. Shareholders are essentially saying, “We are giving you our money, the company, to invest. We expect you to at least earn us as much as we could earn ourselves with similar risk in the financial markets. Otherwise, give us back our money, and we will invest it ourselves.”

Therefore, a firm’s investment project must clear a certain hurdle. This hurdle is set by the expected returns available on financial assets with comparable risk. This ensures that the firm is using its capital wisely and generating value for its investors. If a project doesn’t meet this minimum return requirement, it’s essentially saying that the company is better off returning the money to shareholders, or investing it in those comparable financial assets instead of pursuing that particular project. This principle is fundamental to sound financial decision-making and helps ensure efficient allocation of resources.