Should Firms Invest in Money Market Securities? Point No. Firms are supposed to

Question

Should Firms Invest in Money Market Securities?

Point No. Firms are supposed to use money in a manner that generates an adequate return to shareholders. Money market securities provide a return that is less than that required by shareholders. Thus, firms should not be using shareholder funds to invest in money market securities. If firms need liquidity, they can rely on the money markets for short-term borrowing.

Counter-Point Yes. Firms need money markets for liquidity. If they do not hold any money market securities, they will frequently be forced to borrow to cover unanticipated cash needs. The lenders may charge higher risk premiums when lending so frequently to these firms.

Who Is Correct? Use the Internet to learn more about this issue and then formulate your own opinion.

Explanation / Answer

Both arguments are correct.

A money market investment has both pro and con, there cannot be any absolute decision.

The argument against sayss firm's objective is maximization of shareholder returns, and money markets offer lower rates on investment. This is sub-optimal to shareholder returns.

While this is correct, we must keep in mind another aspect of shareholder return maximization - one that says that shareholders should be subjected to minimum risk. Unlike stock markets, the money market is much less volatile, offering higher stability. So, while returns are lower, risk is lower as well. A higher risk in search of higher returns would have been detrimental to shareholder interest.

The counter-argument says that, frequent borrowing from other sources will raise the overall cost of borrowing, therefore holding money market securities is cheaper.

This is a correct argument as well. Money market securities are highly liquid and the firm can quickly encash its security holdings, which stabilizes the cash requirement timings & amounts.

However, money market investment is not costless either. The brokerage reduces the investment return. The higher the frequency of investing & subsequent encashment, the higher this brokerage expense.

Also, the returns are mostly variable. So exact returns are not known at the time of investment, which reduces certainty.

Weighing both costs and benefits, it is advisable that firms invest in money market funds to meet up short-term liquidity requirments, since these offer relatively low-risk, even though low-return, investments with high liquidity to suit the time of liquidity requirements.

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