Capital Budgeting: NPV Rule and Wealth Maximisation

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

Maximize shareholder wealth, which is equivalent to maximizing the market price of the company's shares

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

Microeconomics has no explicit time dimension, while finance has an explicit time dimension

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

Net present value

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

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

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

Product and labour markets work efficiently Signup and view all the answers

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

It takes into account the time value of money 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?

£10m Signup and view all the answers

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

£7m Signup and view all the answers

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

20% Signup and view all the answers

What is the decision rule for the NPV rule?

Accept if NPV > 0, reject if NPV < 0 Signup and view all the answers

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

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

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

£3.95m Signup and view all the answers

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

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

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

To finance their current consumption by borrowing money. Signup and view all the answers

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

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

What happens when capital markets are imperfect?

Borrowing rates are higher than saving rates. Signup and view all the answers

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

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

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

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

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

£533.4 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?

It increases by £533.4 Signup and view all the answers

Why might an investor delay a project?

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

What is a limitation of conventional DCF-NPV?

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

What should be revised in the conventional NPV rule?

The cost of lost future opportunities Signup and view all the answers

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

To maximize shareholder wealth Signup and view all the answers

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

Firms allocate resources to their most productive use Signup and view all the answers

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

Time dimension is explicit in wealth maximisation Signup and view all the answers

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

To maximise shareholder wealth Signup and view all the answers

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

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

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

Firms make suboptimal investment decisions Signup and view all the answers

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

Efficient product and labour markets Signup and view all the answers

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

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

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

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

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

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

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

The NPV rule is used to maximise shareholder wealth Signup and view all the answers

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

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

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

To reflect the time value of money Signup and view all the answers

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

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

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

It maximizes shareholder wealth Signup and view all the answers

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

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

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

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

What is the limitation of conventional DCF-NPV?

It ignores the costs of lost future opportunities Signup and view all the answers

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

It enables firms to make investment decisions independent of shareholders' preferences. 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?

It increases by the NPV of the project 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?

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

Why might an investor delay a project?

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

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

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

What should be revised in the conventional NPV rule?

The costs of lost future opportunities or the benefits of opportunities gained Signup and view all the answers

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

It leads to undervaluation of projects Signup and view all the answers

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

Presence of multiple IRRs Signup and view all the answers

What is the primary limitation of conventional DCF-NPV?

Ignores the costs of lost future opportunities Signup and view all the answers

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

NPV decreases Signup and view all the answers

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

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

What is the primary limitation of the payback period method?

It ignores the time value of money Signup and view all the answers

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

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

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

The accumulation of cash flows is discounted Signup and view all the answers

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

The NPV is zero Signup and view all the answers

Why does the payback period method encourage cash generation?

Because it values early cash flows over late cash flows Signup and view all the answers

What is a major disadvantage of the payback period method?

It ignores cash flows after the cut-off period Signup and view all the answers

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

Because it is subjective and varies across firms Signup and view all the answers

What is a consequence of using the payback period method?

It leads to the rejection of projects with positive NPVs Signup and view all the answers

What is the primary limitation of the ARR method?

Ignores the time value of money Signup and view all the answers

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

12.5% Signup and view all the answers

What is the formula for calculating the ARR?

Average profit/average investment Signup and view all the answers

What is the primary advantage of the ARR method?

It is easy to compute Signup and view all the answers

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

£71,429 Signup and view all the answers

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

ARR is based on earnings, PI is based on cash flows Signup and view all the answers

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

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

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

The project is not acceptable Signup and view all the answers

What is the primary limitation of the PI method?

It shares some problems with IRR Signup and view all the answers

What is the formula for calculating PI?

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

What is the IRR of Project A?

20% Signup and view all the answers

Capital Budgeting: NPV Rule and Wealth Maximisation

Questions and Answers

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

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

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

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

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

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

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

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

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

What is the decision rule for the NPV rule?

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

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

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

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

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

What happens when capital markets are imperfect?

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

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

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

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

Why might an investor delay a project?

What is a limitation of conventional DCF-NPV?

What should be revised in the conventional NPV rule?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What is the limitation of conventional DCF-NPV?

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

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

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

Why might an investor delay a project?

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

What should be revised in the conventional NPV rule?

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

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

What is the primary limitation of conventional DCF-NPV?

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

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

What is the primary limitation of the payback period method?

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

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

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

Why does the payback period method encourage cash generation?

What is a major disadvantage of the payback period method?

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

What is a consequence of using the payback period method?

What is the primary limitation of the ARR method?

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

What is the formula for calculating the ARR?

What is the primary advantage of the ARR method?

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

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

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

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

What is the primary limitation of the PI method?

What is the formula for calculating PI?

What is the IRR of Project A?

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