Question

Assume that a company has two possible investment opportunities that are not correlated, called Project A and Project B.

1. Assume that managers of the company are rational and the company’s capital allocation is efficient. Why would the managers would want to invest in both Project A and B? Discuss two implications of diversification.

2. Now, assume that the company invested in both projects and it turns out the initial NPV calculation for Project A was incorrect (the NPV is found to be negative). Assume the managerial irrationality and discuss how the diversification can harm the business.

Answer 1

Ans a) In case of NPV calculation we only considered those project which give positive return. In this case since both project are not correlated thus one can considered both project if the NPV is positive because uncorrelated project will reduce the risk due to diversification effect at the same time also provide better return due to diversification effect.

Ans b) One very important thing to considered in case of capital budgeting is that always select project with positive NPV, if it is negative then one should not select the project. One need to very careful while performing NPV analysis and take care of all the assumption and accordingly assign the risk premium other wise it will be a flaw in managerial process. If initial analysis of NPV is changed there is huge question mark on manager's rationality and due to that this diversification will reduce the total return on the project and diversification will not achieve its target.