Question

The company announces that it will make an investment. As a result of the investment, it will have to reduce its dividend to be paid after one year to EUR 3, whereas it was previously expected to pay a dividend of EUR 5 after one year. Prior to the announcement, dividends were expected to grow 2% per year and the company’s share price was € 100.

The new investment is expected to increase the growth rate of dividends to 4 percent. After a dividend of EUR 3 after one year, the dividend will therefore increase by 4% per year as expected.

Assuming that the new investment does not affect the riskiness of the company, what can we deduce from the investment with this information?

Select one:

a. The NPV of the investment is positive.

b. The NPV of the investment is negative.

c. The NPV of the investment is zero.

d. The investment will not pay for itself.

Answer 1

Ans is a. The NPV of the investment is positive.

Explanation: It is given that first the company plan is to distribute EUR 5 in dividend and price of stock was EUR 100, but after making the investment company reduces its Dividend to EUR 3 and growth rate was doubled form 2% to 4%, that means company investment is producing good returns that’s why company is reducing its cash distribution and doubling of growth rate is also a indicator that investment is worthwhile. Since riskiness of company is not increased , it indicates that investment is well planned and increases shareholders wealth. Company reinvest its earning in the project that has only positive NPV, that’s why we can say NPV of investment is positive.

Other options are incorrect, since for negative NPV , its impossible to increase the growth rate, and also for 0 NPV project growth rate cant be revised, so we can say that option B, C and D is not correct.