Laurentian Bakeries
Question 1: Explain the theoretical rationale for the NPV approach to investment appraisal and compare the strengths and weaknesses of the NPV approach to two other commonly used approaches. (30 marks)
This first section of this paper will provide a brief explanation on theoretical rationale for the net present value (NPV) method of investment appraisal and then compare its strengths and weaknesses to two alternative methods of investment appraisal, those of internal rate of return (IRR) and pay-back.
Theoretical rationale for the NPV approach
The net present value rule or NPV devised by Hirshleifer (1958), is the fundamental model of how firms decide whether to invest in a project, commonly known as the ‘investment decision’, or ‘capital budgeting decision’.
With the assumption that a firm’s objective is to maximise shareholder wealth through maximising a company’s market value, firms allocate resources to their most productive use, therefore responding to the needs of stakeholders. As derived by Fisher (1930), when ‘perfect capital markets’ exist (see below for conditions), when a firm only chooses projects with a positive NPVs, they will maximise shareholder wealth.
The following conditions for perfect capital markets are: - Same capital market interest rates, returns and prices for all - Free and equal access to capital markets - No participants have any market power over prices - All participants have the same information - No taxes that distort economic decisions
Fisher’s separation theorem states that the firm’s investment decision is independent of the preferences of the owner, and that investment decision is independent of the financing decision. This means that investment and financing decision can be separated out, and that the type of owner the firm has does not need to be accounted for when making investment decisions (e.g. the firm does not have to invest with low risk because it has risk averse owners). This
This first section of this paper will provide a brief explanation on theoretical rationale for the net present value (NPV) method of investment appraisal and then compare its strengths and weaknesses to two alternative methods of investment appraisal, those of internal rate of return (IRR) and pay-back.
Theoretical rationale for the NPV approach
The net present value rule or NPV devised by Hirshleifer (1958), is the fundamental model of how firms decide whether to invest in a project, commonly known as the ‘investment decision’, or ‘capital budgeting decision’.
With the assumption that a firm’s objective is to maximise shareholder wealth through maximising a company’s market value, firms allocate resources to their most productive use, therefore responding to the needs of stakeholders. As derived by Fisher (1930), when ‘perfect capital markets’ exist (see below for conditions), when a firm only chooses projects with a positive NPVs, they will maximise shareholder wealth.
The following conditions for perfect capital markets are: - Same capital market interest rates, returns and prices for all - Free and equal access to capital markets - No participants have any market power over prices - All participants have the same information - No taxes that distort economic decisions
Fisher’s separation theorem states that the firm’s investment decision is independent of the preferences of the owner, and that investment decision is independent of the financing decision. This means that investment and financing decision can be separated out, and that the type of owner the firm has does not need to be accounted for when making investment decisions (e.g. the firm does not have to invest with low risk because it has risk averse owners). This