Question

In: Finance

A firm is considering two mutually exclusive one-year projects, with the cash flows shown

(i) A firm is considering two mutually exclusive one-year projects, with the cash flows shown below. The cost of capital for both projects is 12%.

a) Compute the NPV and IRR for each project.

b) Indicate whether NPV or IRR should be used to choose one of the two projects.

 

(ii) Do you agree with the following statement and justify your answer. (10 marks)

"Managers have the same incentive as shareholders to maximize firm value".

(iii) Do you think the following statement to be consistent with the efficient market hypothesis? Please also justify your answer. (15 marks)

"The directors of Lotus, the Norfolk-based sports car and engineering group, were able to make abnormal returns on the company's shares just before a public announcement by the company on the results of the new pilot project designed to improve security on its latest models."

Solutions

Expert Solution

i)

a)

NPV of project A = -1000+1200/1.12 

                              = 71.43

 

NPV of project B = -8000+9200/1.12 

                               = 214.29

 

IRR (rA) of project A is given as

-1000+1200/(1 + rA) = 0

=> rA = 20%

 

IRR (rB) of project B is given as

-8000+9200/(1 + rB) = 0

=> rB = 15%

 

b)

NPV criteria should be chosen to select the project and Project B should be selected as the NPV is higher than that in project A.

 

Also, the NPV criteria is consistent with the wealth maximization objective of the firm

 

ii)

I do not agree with the statement that "Managers have the same incentive as shareholders to maximize firm value". Managers are generally employed on Salary basis with bonuses linked to their performance in terms of increasing Sales or Profitability

 

Therefore, the incentives for Managers are to increase Sales (may be at the cost of decreasing profitability) or Increasing profitability (at the cost of quality etc.) which is not good for the firm

 

iii)

As the Directors of Lotus were able to make Abnormal returns based on an Insider Information , it implies that the Market is not exhibiting Strong form of Efficiency. At best , the markets may be Weak form or Semi strong form efficient

 

Thus, the statement is not consistent with the Efficient market hypothesis.


(a) rA = 20%

rB = 15%

(b) Also, the NPV criteria is consistent with the wealth maximization objective of the firm.

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