Chartered Financial Analyst (CFA) Practice Exam Level 2

In decision-making, what should be considered besides the ROE?

1. The volatility of cash flows

2. The required rate of return on investment

3. The historical performance of the stock

4. The current market price

The correct answer is: The required rate of return on investment

In decision-making regarding investments, considering the required rate of return on investment is crucial because it helps assess whether the expected returns justify the level of risk associated with an investment. ROE (Return on Equity) is a measure of a company's profitability relative to shareholders' equity, but it does not provide a comprehensive view of the potential investment's desirability. The required rate of return acts as a benchmark that reflects the risk profile of the investment. An investment yielding a high ROE might still be unfavorable if its returns do not exceed the required rate of return, which incorporates the cost of capital and the risk associated with the investment. Therefore, understanding how the expected returns, as indicated by ROE, compare to the required return allows for more informed investment decisions that consider both profitability and market expectations. Other aspects like volatility of cash flows, historical performance, and current market price might impact overall investment decisions but they do not directly address the fundamental consideration of whether an investment is likely to meet or exceed the investor's required rate of return. Understanding the required return thus places the evaluation of ROE in a broader context of risk and expected return.