Question

Be very detailed and give examples.

"intuitively, we would select the project that returns the most money. Project A has the highest NPV and would be selected on that basis."

What is the significance of selecting projects with the most money?

You will be fully diversified if you invested in all of the stocks listed on the NYSE, but you will not eliminate all of your risks. How would you reduce the risks that you cannot eliminate if you invested in a portfolio of stocks?

Answer 1

NPV is a measure of the value created by the project. It is the excess of the present value of cash inflows, over the initial investment. In other words, it is the return of money on the project.

The significance of selecting projects with the most money is that they create them most value for the firm. Projects with higher NPV create more firm value then projects with higher IRR. For example, there are two projects : A and B. Project A has an IRR of 8% and NPV of $100,000. Project B has an IRR of 12% and NPV of $50,000. In this case, Project A creates more firm value than Project B as its NPV is higher, although it has a lower NPV

Total risk = systematic risk + non-systematic risk. Diversification can eliminate non-systematic risk, but it cannot reduce systematic risk. Systematic risk is the market risk - the risk that the prices of all stocks move together. Systematic risk can be reduced but not eliminated. Systematic risk of a portfolio of stocks can be reduced in two ways :

• Adding other asset classes to the portfolio. For example, by investing in other asset classes such as bonds, commodities, real estate etc., the overall systematic risk of the portfolio can be reduced
• Hedging - systematic risk can be reduced by hedging the portfolio with hedging instruments such as futures or options. For example, a futures contract can be sold to reduce the systematic risk of a long-only equity portfolio