In what types of situations would capital budgeting decisions be made solely on the basis of a project's net present value (NPV)? Identify potential reasons that might drive higher NPV for a given project. Substantiate your response by providing an example to explain your thought process.
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Capital budgeting
Sample Answer
Capital budgeting decisions would be made solely on the basis of a project's Net Present Value (NPV) in situations where the firm's primary objective is shareholder wealth maximization and the projects being evaluated are:
Independent: The decision to accept or reject one project does not affect the decision for any other project.
Non-Mutually Exclusive: The firm has sufficient capital to invest in all projects with a positive NPV.
Standard and Single-Period: The projects do not involve complex strategic options, significant real options (like the option to expand or abandon), or dramatically different useful lives that might favor another metric.
The foundational reason for relying solely on NPV in these situations is that NPV measures the increase in firm value (wealth) in absolute dollar terms resulting from undertaking a project, making it the most theoretically sound method aligned with the goal of maximizing shareholder value. The NPV Rule states: Accept all independent projects with $\text{NPV} > 0$.
Factors Driving Higher NPV $\uparrow$
The Net Present Value is the difference between the present value of all expected future cash inflows and the present value of all cash outflows (the initial investment).
Therefore, any factor that increases the present value of future cash inflows or decreases the present value of the cash outflows will drive a higher NPV.
| Element | Effect on NPV | Potential Reasons |
|---|---|---|
| Cash Inflows ($\uparrow$) | Higher NPV | Higher Revenue/Sales: Unique product, superior marketing, higher market share. Lower Operating Costs: Efficient technology, cheaper labor, better supply chain. |
| Initial Investment ($\downarrow$) | Higher NPV | Lower Purchase Price: Securing assets at a discount, government subsidies, or tax breaks. |
| Timing of Cash Flows (Faster) | Higher NPV | Quick Cash Realization: Projects with high sales/revenue early in their life due to a shorter payback period. |
| Discount Rate ($r$) ($\downarrow$) | Higher NPV | Lower Cost of Capital: Better credit rating, lower risk profile for the project, or favorable debt financing terms. |
| Project Life ($n$) ($\uparrow$) | Higher NPV | Longevity: A product with a durable competitive advantage or a facility with a longer economic life. |
$\text{Substantiating Example}$
Consider a company, Global Tech Corp, evaluating two projects for a new line of electronic charging stations. Both projects require the same initial investment and have the same expected life. The goal is to maximize shareholder wealth, so the decision should be based solely on NPV.
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