Question

Subject : Corporate Finance Theory

Please provide me answers with details that is based on the corporate finance theories

Q.

The NPV rule suggests that a firm must invest in all positive NPV projects regardless of the cash amount that the firm has. In practice, however, the firm’s investment amount relies heavily on its financing capacity (e.g., cash holdings or availability of new debt issuance).

Discuss why the firm’s investment decisions do not follow the NPV rule and are rather influenced by its financing capacity?

Answer 1

Investment decisions donot follow NPV rule because of following reasons
1. NPV fails to accept projects when they have limited capital. Since NPV chooses projects which has higher increase in value, but companies may not have the requisite capital for investment.
2. In case of limitation of financing capacity Profitability index method is better than NPV method.Profitability Index is the ratio of PV of Cash flows to initial Investment. It can also be calculated by following formula.PI =1+NPV/Investment. PI index should be greater than 1 for a project to be accepted. In case of mutually exclusive projects higher PI index project should be accepted.