Capital Budgeting: Net Present Value Rule and Wealth Maximisation
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Questions and Answers

What is the required initial investment for the property development firm's proposal to build an out-of-town shopping centre?

  • £15m
  • £5m
  • £20m
  • £10m (correct)

    • What is the required rate of return for investors in this type of venture?

  • 15%
  • 20% (correct)
  • 25%
  • 30%

    • What is the decision rule for accepting or rejecting a project based on the NPV rule?

  • Reject if NPV > 0, accept if NPV < 0
  • Accept if NPV < 0, reject if NPV > 0
  • Accept if NPV = 0, reject if NPV ≠ 0
  • Accept if NPV > 0, reject if NPV < 0 (correct)

    • What is one of the conditions of a perfect capital market (PCM)?

    <p>There are no transactions costs or other 'frictions' to accessing capital markets</p> Signup and view all the answers

    What is the NPV of the property development firm's proposal if the discount rate is 20%?

    <p>£3.95m</p> Signup and view all the answers

    What is the theorem that states that companies can make their investment decisions independently of individual shareholders' consumption decisions?

    <p>Fisher's separation theorem</p> Signup and view all the answers

    What is the assumption about taxes in the perfect capital market (PCM) framework?

    <p>There are no distorting taxes</p> Signup and view all the answers

    What is the main implication of Fisher's separation theorem for firms?

    <p>Firms should accept positive NPV projects</p> Signup and view all the answers

    What is the advantage of using market interest rates and returns to calculate NPVs in a PCM framework?

    <p>It gives the correct trade-offs between current and future consumption</p> Signup and view all the answers

    What happens when impatient investors want to borrow and consume more than their income in a PCM framework?

    <p>They want the firm to use a higher discount rate</p> Signup and view all the answers

    What is the assumption about shareholders in a PCM framework?

    <p>Shareholders can sell or buy shares and other securities, or borrow and lend to get their desired consumption-savings pattern</p> Signup and view all the answers

    What is the implication of imperfect capital markets for firms' investment decisions?

    <p>Firms should use a higher discount rate for impatient investors and a lower discount rate for patient investors</p> Signup and view all the answers

    What is the primary goal of a firm according to the concept of wealth maximisation?

    <p>Maximise shareholder wealth</p> Signup and view all the answers

    What is the key difference between microeconomics and finance in relation to profit maximisation?

    <p>Time dimension is implicit in microeconomics and explicit in finance</p> Signup and view all the answers

    What is the name of the rule that managers should use when taking decisions according to the concept of wealth maximisation?

    <p>The Net Present Value (NPV) rule</p> Signup and view all the answers

    Who benefits when firms maximise shareholder wealth?

    <p>Society as a whole</p> Signup and view all the answers

    What is the relationship between wealth and profit in the context of microeconomics?

    <p>Wealth is the same as profit</p> Signup and view all the answers

    What is the outcome when firms maximise shareholder wealth?

    <p>Firms respond to the needs of other stakeholders</p> Signup and view all the answers

    What is the NPV of the project with a required return of 15%?

    <p>£533.4</p> Signup and view all the answers

    What happens to the market value of the firm if the market had not previously anticipated the investment?

    <p>It increases by £533.4</p> Signup and view all the answers

    Why might a project be delayed?

    <p>Because interest rates might fall or expected cash flows might increase</p> Signup and view all the answers

    What is a limitation of the conventional DCF-NPV approach?

    <p>It ignores the costs of lost future opportunities</p> Signup and view all the answers

    Under what condition does the NPV rule maximise shareholder wealth?

    <p>Under PCM, using the NPV rule</p> Signup and view all the answers

    What type of investment decisions have interdependencies through time?

    <p>Strategic investment decisions</p> Signup and view all the answers

    What would be the consequence of using a cut-off of 14% if we focus on the NPV curve to the left of 15.47%?

    <p>We would accept the project though NPV is negative</p> Signup and view all the answers

    What is the relationship between the NPV of Project A and Project B if the market required return is 12%?

    <p>NPV (Project A) is less than NPV (Project B)</p> Signup and view all the answers

    What is the crossover rate in the NPV profile of Project A and Project B?

    <p>12.5%</p> Signup and view all the answers

    What is the formula for calculating the Accounting Rate of Return (ARR)?

    <p>ARR = (Average accounting profits / Average book value of assets)</p> Signup and view all the answers

    What is the decision rule based on the NPV rule if NPV is greater than zero?

    <p>Accept the project</p> Signup and view all the answers

    What is the formula for calculating the ARR?

    <p>Average profit / Average investment</p> Signup and view all the answers

    What is the main drawback of the ARR method?

    <p>It does not consider the time value of money</p> Signup and view all the answers

    What is the primary drawback of the payback period method?

    <p>It ignores the time value of money.</p> Signup and view all the answers

    What is the advantage of using the ARR method?

    <p>It is easy to compute because it uses accounting information</p> Signup and view all the answers

    Which of the following is an advantage of the payback period method?

    <p>It encourages cash generation.</p> Signup and view all the answers

    What is the formula for calculating the Profitability Index (PI)?

    <p>PV of future cash flows / Initial investment</p> Signup and view all the answers

    What is the key difference between the payback period and discounted payback period methods?

    <p>The discounted payback period method considers the time value of money.</p> Signup and view all the answers

    What is the consequence of using a short cut-off period in the payback period method?

    <p>It leads to the rejection of more projects.</p> Signup and view all the answers

    What is the decision rule for accepting or rejecting a project based on the PI?

    <p>Accept if PI &gt; 1, reject if PI &lt; 1</p> Signup and view all the answers

    What is the implication of using the payback period method with a 3-year cut-off period?

    <p>It is biased towards rejecting short-lived projects.</p> Signup and view all the answers

    What is a limitation of the ARR method?

    <p>It ignores the time value of money</p> Signup and view all the answers

    What is the advantage of using the discounted payback period method over the payback period method?

    <p>It considers the time value of money.</p> Signup and view all the answers

    What is the reason behind the bias against short-lived projects in the NPV method?

    <p>Time value of money</p> Signup and view all the answers

    What is the implication of having multiple IRRs for a project?

    <p>The project has multiple acceptable solutions</p> Signup and view all the answers

    What is the decision rule based on the IRR method?

    <p>Accept if IRR &gt; required return</p> Signup and view all the answers

    What is the problem with mutually exclusive projects in the DCF-NPV method?

    <p>They cannot be compared</p> Signup and view all the answers

    What is the assumption behind the DCF-NPV method?

    <p>Discount rate is constant</p> Signup and view all the answers

    What is a limitation of the conventional DCF-NPV approach?

    <p>Ignores non-conventional cash flows</p> Signup and view all the answers

    What is the primary reason for calculating the taxable operating profits attributable to a project?

    <p>To calculate the corporation taxes associated with the project</p> Signup and view all the answers

    Why do we need to convert accounting profits into cash flows when implementing the NPV rule?

    <p>Because depreciation is not a cash flow</p> Signup and view all the answers

    What is the purpose of calculating the before-tax incremental operating cash flows from a project?

    <p>To deduct taxes and include net capital spending</p> Signup and view all the answers

    What is the relationship between capital allowances and depreciation?

    <p>Capital allowances are governed by tax law, while depreciation is an accounting concept</p> Signup and view all the answers

    What is the purpose of including changes in working capital when calculating after-tax cash flows?

    <p>To account for changes in investments in stocks or cash</p> Signup and view all the answers

    Why do we need to discount cash flows at the project's required rate of return when calculating the NPV?

    <p>To reflect the time value of money</p> Signup and view all the answers

    What is the purpose of using an after-tax discount rate in capital budgeting decisions?

    <p>To reflect the project's weighted average cost of capital</p> Signup and view all the answers

    What is the relevance of incremental cash flows in capital budgeting decisions?

    <p>They represent the difference between the project's cash flows with and without the project</p> Signup and view all the answers

    What is the formula for calculating the project's weighted average cost of capital (WACC)?

    <p>reE/V + rd(1 - Tc)D/V</p> Signup and view all the answers

    Why are arbitrarily allocated costs irrelevant in capital budgeting decisions?

    <p>They are not incremental to the project</p> Signup and view all the answers

    What is the purpose of calculating the NPV of a project?

    <p>To determine the project's viability and make an accept/reject decision</p> Signup and view all the answers

    What is the assumption behind the use of nominal discount rates in capital budgeting decisions?

    <p>That the project's cash flows are nominal</p> Signup and view all the answers

    What percentage of large UK firms use DCF/NPV method for investment appraisal?

    <p>44%</p> Signup and view all the answers

    Which of the following methods is used by the highest percentage of small UK firms?

    <p>Payback</p> Signup and view all the answers

    What is the primary criticism of UK investment performance?

    <p>Myopic management</p> Signup and view all the answers

    In the capital budgeting process, what is the purpose of the definition stage?

    <p>To define the project and its alternatives</p> Signup and view all the answers

    What is the primary source of a positive NPV?

    <p>Economic rents</p> Signup and view all the answers

    What is the effect of using a high discount rate for cash flows after a certain year?

    <p>It decreases the present value of the cash flows</p> Signup and view all the answers

    What is the primary reason for using a 12-month detailed capital budget and a 2/4-year outline plan?

    <p>To ensure that projects are consistent with the strategic plan</p> Signup and view all the answers

    What percentage of large UK firms use formal risk analysis for investment appraisal?

    <p>26%</p> Signup and view all the answers

    What is the main limitation of using a high discount rate for cash flows?

    <p>It understates the present value of the cash flows</p> Signup and view all the answers

    What is the relationship between a positive NPV and economic rents?

    <p>A positive NPV is a necessary condition for economic rents</p> Signup and view all the answers

    What is the main implication of using a high discount rate for cash flows after a certain year?

    <p>It decreases the NPV of the project</p> Signup and view all the answers

    What is the primary source of uncertainty in cash flows?

    <p>Forecasting errors</p> Signup and view all the answers

    What is the primary objective of post-completion audits in capital budgeting?

    <p>To improve the quality of future decisions</p> Signup and view all the answers

    Which of the following is a problem in implementing post-audits?

    <p>Measuring incremental cash flows</p> Signup and view all the answers

    What is the primary reason for using risk-adjusted discount rates in capital budgeting?

    <p>To account for project risk</p> Signup and view all the answers

    What is the primary implication of using historical cost accounting in capital budgeting?

    <p>It overstates the project's profitability</p> Signup and view all the answers

    What is the primary objective of capital budgeting in practice?

    <p>To evaluate projects using multiple investment appraisal criteria</p> Signup and view all the answers

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