Most financial decisions involve alternative courses of action. The alternatives have different returns and risk. For example, should we buy a replacement machine now or should we wait until next year, should we set the debt-to-assets ratio at 20%, 40% or any other ratio?
The higher the risk on any decision, the higher the required return to compensate for this risk.
The relationship between Return and Risk can be expressed as follows:
Required Rate of Return = Risk-free rate + Risk premium.
Risk free rate is compensation for time and risk premium is compensation for risk of financial actions. It can be seen that the relationship is direct.
The finance manager should avoid decisions with unnecessary risk. In making financing decisions for example, the finance manager must decide whether to finance with equity alone or to use debt as well. The expected return when debt is used is high since the cost of debt is low.
However, since payment of interest on debt is compulsory, the risk involved is high. On the other hand the cost of equity is high and therefore the return is low. The risk is also low since payment of ordinary dividend is not compulsory. The firm’s liquidity decisions will also affect the risk and the return of the firm.