Management Notes

Reference Notes for Management

Which best describes how an investor makes money from an equity investment?

Which best describes how an investor makes money from an equity investment?

A. By earning interest
B. By selling the asset for a profit
C. By raising capital
D. By growing the asset

Correct Answer: B. By selling the asset for a profit

Answer Explanation:

An equity investment refers to the purchase of shares or ownership stakes in a company. When an investor buys equity, they essentially buy a small portion of that company.

Investors make money from equity investments mainly in two ways: capital gains (selling the asset for a profit) and dividends (earnings paid to shareholders). However, the primary method is by selling the shares at a price higher than what they originally paid.

Why Option B is Correct: Selling for Profit

When an investor purchases equity, they are essentially betting that the value of the company will increase over time. The value of the company’s stock can rise due to various factors like strong financial performance, successful business strategies, and growth in the market.

If the stock price goes up, the investor can sell the shares for more than what they paid, making a capital gain. This is the most common and direct way to make money from an equity investment. The process of selling an asset for a profit is called realizing a capital gain.

For example, let’s say an investor buys 100 shares of a company at $10 each, totaling $1,000. Over time, the company performs well, and the share price increases to $15 each. If the investor sells all 100 shares, they receive $1,500, which means a profit of $500.

This capital gain is the money made from selling the asset (equity) for more than its original purchase price. This is why selling the asset for a profit is the most accurate description of how an investor makes money from equity investments.

Why the Other Options Are Incorrect:

A. By Earning Interest

Earning interest is typically associated with debt investments, not equity investments. When you invest in bonds or other debt instruments, the investor earns interest over time.

In contrast, equity investors don’t receive interest; they benefit from the company’s performance through dividends or capital gains. Equity investors own a part of the company, and their profit is tied to the success of the business, not regular interest payments.

C. By Raising Capital

Raising capital refers to the process through which companies obtain funds, often by issuing equity or debt. However, this is not how investors make money. When companies raise capital by issuing new shares, they sell a portion of the company to investors in exchange for money.

Investors may purchase these shares, but the act of raising capital benefits the company, not the investor. Investors make money when the value of their shares increases, not by the company’s fundraising activities.

D. By Growing the Asset

While it is true that the value of an asset like equity can grow over time, the phrase “growing the asset” is too vague and doesn’t accurately describe how investors make money.

Growth in the asset’s value refers to the increase in stock price due to the company’s performance, but simply holding the asset doesn’t guarantee a profit unless the investor sells the shares for more than they paid.

Growth happens when the company performs well, but selling for a profit is the way an investor actually realizes the value of that growth.

Conclusion:

The best way an investor makes money from an equity investment is by selling the asset for a profit. Equity investments involve purchasing shares of a company and benefiting from its growth, either through capital gains or dividends.

Among the given options, option B most accurately reflects the process of making money from an equity investment, as it focuses on realizing profit from the increased value of the investment.

References:

  • Koller, G., & Goedhart, M. (2015). Valuation: Measuring and managing the value of companies (6th ed.). John Wiley & Sons.
  • Merton, R. C., & Bodie, Z. (2005). The design of financial systems: Towards a synthesis of function and structure. Journal of Investment Management, 3(1), 1-23.
  • Graham, B., & Dodd, D. L. (2008). Security analysis: Sixth edition. McGraw-Hill.
Smirti

Leave a Comment