Most financial decisions involve alternative courses of action. For example, should a hospital invest its excess funds in Treasury bonds that yield 6 percent or in HCA bonds that yield 9 percent? Should a group practice buy a replacement piece of equipment now or wait until next year? Should a joint venture outpatient diagnostic center purchase a small, limited-use MRI system or a large, and more expensive, multipurpose system?
Generally, such alternative courses of action will have different expected rates of return, and one may be tempted to automatically accept the alternative with the higher expected return. However, this approach to financial decision making would be incorrect. In efficient markets, those alternatives that offer higher returns will also entail higher risk.
The correct question to ask when making financial decisions is not which alternative has the higher expected rate of return, but which alternative has the higher return after adjusting for risk. In other words, which alternative has the higher return over and above the return commensurate with that alternative’s riskiness?
To illustrate the risk/return trade-off, suppose HCA stock has an expected rate of return of 14 percent, while its bonds yield 9 percent.
Does this mean that investors should flock to buy the firm’s stock and ignore the bonds? Of course not. The higher expected rate of return on the stock merely reflects the fact that the stock is riskier than the bonds. Those investors who are not willing to assume much risk will buy HCA’s bonds, while those that are less risk averse will buy the stock. From the perspective of HCA’s managers, financing with stock is less risky than using debt, so the firm is willing to pay the higher cost of equity to limit the firm’s risk exposure.
