Capital Budgeting: NPV Rule and Wealth Maximisation
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Questions and Answers

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

  • Maximize dividend growth
  • Maximize customer satisfaction
  • Maximize the size of the firm
  • Maximize shareholder wealth, which is equivalent to maximizing the market price of the company's shares (correct)

    • What is the key difference between microeconomics and finance in their approach to profit maximization?

  • Microeconomics focuses on profit maximization, while finance focuses on wealth maximization
  • Microeconomics considers profit maximization, while finance considers wealth maximization
  • Microeconomics has no explicit time dimension, while finance has an explicit time dimension (correct)
  • Microeconomics has an explicit time dimension, while finance does not

    • What is the primary criterion that managers should use when making decisions, according to the NPV rule?

  • Accounting rate of return
  • Net present value (correct)
  • Payback period
  • Internal rate of return

    • What is the relationship between maximising shareholder wealth and the needs of other stakeholders?

    <p>Maximising shareholder wealth will benefit society and automatically respond to the needs of other stakeholders</p> Signup and view all the answers

    What is the key assumption underlying the concept of wealth maximization?

    <p>Product and labour markets work efficiently</p> Signup and view all the answers

    What is the primary advantage of using the NPV rule in capital budgeting decisions?

    <p>It takes into account the time value of money</p> Signup and view all the answers

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

    <p>£10m</p> Signup and view all the answers

    What is the expected cash flow for year 2 and year 3 according to the proposal?

    <p>£7m</p> Signup and view all the answers

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

    <p>20%</p> Signup and view all the answers

    What is the decision rule for the NPV rule?

    <p>Accept if NPV &gt; 0, reject if NPV &lt; 0</p> Signup and view all the answers

    What is a condition for a perfect capital market (PCM) according to Irving Fisher’s separation theorem?

    <p>All participants have the same information about prices and security/firm characteristics</p> Signup and view all the answers

    What is the NPV of the proposal calculated using the discounted cash flow approach?

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

    What is the primary implication of the Fisher's separation theorem on a firm's investment decisions?

    <p>The firm's investment decision is independent of shareholders' preferences for current versus future consumption.</p> Signup and view all the answers

    What is the primary reason why impatient investors would want the firm to use a higher discount rate?

    <p>To finance their current consumption by borrowing money.</p> Signup and view all the answers

    What is the primary benefit of Perfect Capital Markets (PCMs) to shareholders?

    <p>PCMs enable shareholders to get their desired consumption – saving pattern.</p> Signup and view all the answers

    What happens when capital markets are imperfect?

    <p>Borrowing rates are higher than saving rates.</p> Signup and view all the answers

    Why do both impatient and patient investors want the firm to accept positive NPV projects?

    <p>Because it increases their wealth and enables them to finance their desired consumption patterns.</p> Signup and view all the answers

    What is the primary role of market interest rates and returns in PCM?

    <p>To provide the opportunity costs of transferring wealth across different periods.</p> Signup and view all the answers

    What is the NPV of the project given the cash flows and required return?

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

    What happens to the market value of the firm's equity capital if the market had not previously anticipated the project?

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

    Why might an investor delay a project?

    <p>To wait for interest rates to fall or expected cash flows to increase</p> Signup and view all the answers

    What is a limitation of conventional DCF-NPV?

    <p>It assumes a once-for-all, now-or-never decision</p> Signup and view all the answers

    What should be revised in the conventional NPV rule?

    <p>The cost of lost future opportunities</p> Signup and view all the answers

    What is the primary goal of using the NPV rule under the PCM?

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

    Which of the following is a consequence of maximising shareholder wealth in a perfect capital market?

    <p>Firms allocate resources to their most productive use</p> Signup and view all the answers

    What is the primary difference between wealth maximisation and profit maximisation in finance?

    <p>Time dimension is explicit in wealth maximisation</p> Signup and view all the answers

    Why do managers use the NPV rule when making investment decisions?

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

    What is the relationship between the NPV rule and the firm's investment decisions?

    <p>The NPV rule is a primary criterion for investment decisions</p> Signup and view all the answers

    What is the consequence of imperfect capital markets on a firm's investment decisions?

    <p>Firms make suboptimal investment decisions</p> Signup and view all the answers

    What is the primary assumption underlying the concept of wealth maximisation?

    <p>Efficient product and labour markets</p> Signup and view all the answers

    Under what conditions does the NPV rule maximise share price and shareholders' wealth?

    <p>When the firm's investment decisions are independent of individual shareholders' consumption decisions</p> Signup and view all the answers

    What is the primary implication of Irving Fisher's separation theorem on a firm's investment decisions?

    <p>Firms can make investment decisions independently of individual shareholders' consumption decisions</p> Signup and view all the answers

    What is the primary advantage of using the discounted cash flow approach to calculate NPV?

    <p>It provides a more accurate estimate of the project's NPV</p> Signup and view all the answers

    What is the relationship between the NPV rule and the goal of maximising shareholder wealth?

    <p>The NPV rule is used to maximise shareholder wealth</p> Signup and view all the answers

    What is the primary assumption underlying the concept of wealth maximization?

    <p>Firms can make investment decisions independently of individual shareholders' consumption decisions</p> Signup and view all the answers

    What is the primary role of the discount rate in the NPV calculation?

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

    What is the primary benefit of Perfect Capital Markets (PCMs) to shareholders?

    <p>It enables them to make consumption-smoothing decisions.</p> Signup and view all the answers

    What is the implication of the NPV rule on shareholder wealth?

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

    What is the primary implication of the Fisher's separation theorem on a firm's investment decisions?

    <p>Firms should base their investment decisions solely on market interest rates and returns.</p> Signup and view all the answers

    Why do impatient investors want the firm to use a higher discount rate?

    <p>Because they want to consume more than their income.</p> Signup and view all the answers

    What is the limitation of conventional DCF-NPV?

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

    What is the primary advantage of Perfect Capital Markets (PCMs) in capital budgeting decisions?

    <p>It enables firms to make investment decisions independent of shareholders' preferences.</p> Signup and view all the answers

    What happens to the market value of the firm's equity capital if the market had not previously anticipated the project?

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

    What happens to the market value of the firm's equity capital if the market had not previously anticipated the project?

    <p>It increases by the present value of the project's cash flows.</p> Signup and view all the answers

    Why might an investor delay a project?

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

    What is the primary role of market interest rates and returns in Perfect Capital Markets (PCMs)?

    <p>To reflect the opportunity costs of transferring wealth across different periods.</p> Signup and view all the answers

    What should be revised in the conventional NPV rule?

    <p>The costs of lost future opportunities or the benefits of opportunities gained</p> Signup and view all the answers

    What is a consequence of ignoring the costs of lost future opportunities in conventional DCF-NPV?

    <p>It leads to undervaluation of projects</p> Signup and view all the answers

    What is the main issue with non-conventional cash flows in a DCF-NPV analysis?

    <p>Presence of multiple IRRs</p> Signup and view all the answers

    What is the primary limitation of conventional DCF-NPV?

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

    What happens to the NPV when the discount rate is increased?

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

    What is the primary advantage of using the IRR method for project evaluation?

    <p>Provides a clear accept/reject decision rule</p> Signup and view all the answers

    What is the primary limitation of the payback period method?

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

    What is the primary difference between the NPV and IRR methods?

    <p>NPV provides an absolute value, while IRR provides a rate of return</p> Signup and view all the answers

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

    <p>The accumulation of cash flows is discounted</p> Signup and view all the answers

    What happens when the IRR is equal to the cost of capital?

    <p>The NPV is zero</p> Signup and view all the answers

    Why does the payback period method encourage cash generation?

    <p>Because it values early cash flows over late cash flows</p> Signup and view all the answers

    What is a major disadvantage of the payback period method?

    <p>It ignores cash flows after the cut-off period</p> Signup and view all the answers

    Why is the choice of cut-off period in the payback period method arbitrary?

    <p>Because it is subjective and varies across firms</p> Signup and view all the answers

    What is a consequence of using the payback period method?

    <p>It leads to the rejection of projects with positive NPVs</p> Signup and view all the answers

    What is the primary limitation of the ARR method?

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

    What is the crossover rate at which Project A and Project B have the same NPV?

    <p>12.5%</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 primary advantage of the ARR method?

    <p>It is easy to compute</p> Signup and view all the answers

    If the market required return is 12%, what is the NPV of Project A?

    <p>£71,429</p> Signup and view all the answers

    What is the primary difference between the ARR and PI methods?

    <p>ARR is based on earnings, PI is based on cash flows</p> Signup and view all the answers

    What is the accounting rate of return (ARR) formula?

    <p>Investment’s average accounting profits each year / average book value of assets invested each year</p> Signup and view all the answers

    If a project has a negative NPV, what does it indicate?

    <p>The project is not acceptable</p> Signup and view all the answers

    What is the primary limitation of the PI method?

    <p>It shares some problems with IRR</p> Signup and view all the answers

    What is the formula for calculating PI?

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

    What is the IRR of Project A?

    <p>20%</p> Signup and view all the answers

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