Question

Question Two:

(A)

What is the likely response by the stock market when a firm announces a positive NPV project? Is there

any reason to believe that this response might sometimes be negative?

(B)

The IRR of normal project X is greater than the IRR of normal project Y, and both IRR's are greater than

zero. (A normal project is defined as having a cash outflow in time 0 and cash inflows in all subsequent

periods). Also, the NPV of X is greater than the NPV of Y at the cost of capital. If the two projects are

mutually exclusive, Project X should definitely be selected, and the investment made, provided we have

confidence in the data. Put another way, it is impossible to draw NPV profiles that would suggest not accepting Project X.

(true/false/uncertain) Explain your answer.

Answer 1

1:The stock price will increase in anticipation of higher profits. Suppose the project is very high risk, the stock price may decline due to high amount of risk passing to the shareholders even though NPV is positive.

2: TRUE

IRRX>IRRy>0

NPVx> NPVy

Since the IRR of project X is greater than Y, it implies greater returns from project X. Also the NPV of X Is higher which means greater dollar returns from X. So Project X should be selected. NPV profile determines NPV at various discount rates. Since NPV of X is higher at the cost of capital it will alsway be so at other rates. Hence the profiles will always suggest preference of X over Y.