Long-term commitment of funds may also change the risk complexion of the firm: If adoption of an investment increases average gain, but causes frequent fluctuations in its earnings, the rum will become more risky. Thus investment decisions shape the basic character of a firm.
- Funding – Investment decisions generally involve large amount of funds, which make it imperative for the firm to plan its investment programmers very carefully and make advance arrangement for procuring finances internally or externally.
- Irreversibility – Most investment decisions are irreversible. It is difficult to find a market of such capital items once they have been acquired. The firm will incur heavy losses if such assets are scrapped.
- Complexity – Investment decisions are among the rum’s most difficult decisions. They are an assessment of future events, which are difficult to predict. It is really a complex problem to correctly estimate future cash flows of an investment. The cash flow uncertainty is caused by economic, political, social and techno-logical forces.
Following are some of the sources of risk.
- Interest Rate Risk: It is the variability in a security’s return resulting from changes in the level of interest rates. Other factors being equal, security prices move inversely to interest rates. This risk affects bondholders more directly than equity investors.
- Market Risk: This refers to the variability of returns due to fluctuations in the security’s market. All securities, especially equities, are exposed to market risk as they are subjected to being impacted by depressions, wars, politics, etc.
- Inflation Risk: A rise in inflation leads to a reduction of purchasing power and affects all securities. This risk is tied to interest rate risk because interest rate goes up with a rise in inflation.
- Business Risk: This is the risk associated with a particular industry or environment. It further impacts the investors who have invested that sector or industry.
- Financial Risk: When a company resorts to financial leverage or the use of debt financing, financial risk occurs. This risk increases when the company resorts to debt financing.
- Liquidity Risk: Liquidity risk is mostly associated with the secondary markets in which the security is traded. A security is considered liquid when it can be bought or sold quickly without concessions on the price. Liquidity risk increases with the rise in the uncertainty of time and price concession.
