Damodaran on Valuation

10.2. FINANCIAL INVESTMENTS

So far in this chapter, we have looked at holdings of cash and near-cash investments. In some cases, firms invest in more risky securities, which can range from investment-grade bonds to high-yield bonds to publicly traded equity in other firms. In this section, we examine the motivation, consequences, and accounting for such investments.

10.2.1. Reasons for Holding Risky Securities

Why do firms invest in risky securities? Some firms do so for the allure of the higher returns they can expect to make investing in stocks and corporate bonds, relative to Treasury bills. In recent years, there has also been a trend for firms to take equity positions in other firms to further their strategic interests. Still other firms take equity positions in firms they view as undervalued by the market. And finally, investing in risky securities is part of doing business for banks, insurance companies, and other financial services companies.

10.2.1.1. To Make a Higher Return

Near-cash investments such as Treasury bills and commercial paper are liquid and have little or no risk, but they also earn low returns. When firms have substantial amounts invested in marketable securities, they can expect to earn considerably higher returns by investing in riskier securities. For instance, investing in corporate bonds will yield a higher interest rate than investing in Treasury bonds, and the rate will increase with the riskiness of the investment. Investing in stocks will provide ...