Max Corporation has $10,000 in retained earnings that it has not distributed to

Question

Max Corporation has $10,000 in retained earnings that it has not distributed to its stockholders as dividends. It has a choice to invest the funds in a certificate of deposit at a bank at a guaranteed rate of 7 percent, or to plow back the funds in the expansion of its own operation.

If the expected return on the plowback is 12 percent, 10 percent 8 percent, or 6 percent, what would be the best choice for the Max Corporation?

If the stockholders are risk averse, and on average need a 2 percent compensation for assuming risk, what choices should the firm make?

Explanation / Answer

Mas Corporation can get a guaranteed return of 7 percent even though the return of the plowback varies from 10 percent to 6 percent. Since the stockholdrs are risk averse and needs 2 percent compensatioin for assuming rish, the company should think of a combination of investment portfolio.

It should invest in guaranteed investment that offers 7 per cent interest, and also think of ploughing back the funds in operation as well. Max Corporation can think of a 70 to 30 proportion or 60 to 40 option. Which means it can think of long term guaranteed investment returns and also diversify their businsess involving short term risks.

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