Question

Applying the Efficient Market Hypothesis (EMH) to capital budgeting, which of the following statements is correct?   

Group of answer choices

In an efficient market the NPV for projects should on average be positive.

Existing large firms can be considered evidence that the EMH is true.

Existing large firms may exist because they may not have played the game long enough meaning they may still go insolvent.

Firms can be considered to be a collection of projects; and existing firms a collection of negative
NPV projects.

If firms produce new information or technology, this could never be a reason for a firm to produce a NPV.

Answer 1

The Efficient Market Hypothesis (EMH) states that the stocks are always traded at their fair value during the process of exchange which implies that there is absence of any sort of arbitrage and the share prices reflects all information associated.

Capital Budgeting is a method of ranking the investment projects on the basis of their potential future returns.

Out of the above five statements, statement 1 and 2 are correct.

Statement 1 is correct because in an efficient market since investors are able to sell and purchase the stocks at a fair market value. So NPV associated with the projects can be computed properly. NPV (Net Present Value) is the difference between current value of total cash inflow and current value of total cash outflow computed at different point of time. Thus, a positive NPV implies that a project is worthwhile to accept).

Statement 2 is also correct because the functioning of existing large firms can be taken as a basis for determining whether the EMH is applied or not.

Statement 3 is not correct because since there is no chance of arbitrage and imperfect information, the existing firm can’t go insolvent.

Statement 4 is also not correct as it can’t be possible for an existing firm undertaking a collection of projects with negative NPV.

Statement 5 is also not correct because even if a firm is producing new information and technology, it has to consider NPV to determine the potential use of those information and technology in relevant sectors.