Question

Your firm’s has a new product which you expect to be a “great success, it will be big, really great” and generate a higher ROE than previous projects. How would you expect this to influence your firm’s future reinvestment decisions? What other factors would you expect to be affected?

Answer 1

Capital is always a constraint in investment for all firms. A higher ROE than previous products is not sufficient - it should generate higher return than the cost of capital for the product. In this way it can generate shareholders wealth. But an equally important decision is to take into account opportunity cost. If somewhere else we can make more return for similar size, then we should accept it. However, as the case mentions that the product is the best, we can assume no other better alternative is available.

Now, if the product is good, it would require reinventments. If we are sure that the product has growth potential then looking into the cost of equity we can consider reinvesting. The other option is giving dividends but if cost of equity is higher, we can use self generated fund and reinvest it.