The Marginal Cost of Capital
The cost of capital should ideally reflect the riskiness of the future cash... Read More
Projects which have a positive NPV should, in theory, increase the value of a company as well as the value of its stock. This could help explain the popularity of NPV as a capital budgeting evaluation method.
Relationship Among NPV, Company Value, and Share Price
If a company invests in a positive NPV project, the expectation is that shareholder wealth as well as the company’s stock value will be increased.
Crudely speaking, the market value of the company would be expected to increase by the NPV amount. The stock price would also be expected to increase by the NPV per share, i.e., the NPV divided by the number of outstanding shares. The effect of a project’s NPV is, however, more complicated than this.
To an analyst, the impact of an investment on a company’s stock price depends on whether or not the profitability of the investment is more or less than expected. For example, a company’s project may have a positive NPV, but if its profitability is less than what analysts expect, then the company’s stock price might fall.
It is worth appreciating that news of a project that has a positive NPV sends a positive signal to the markets, causing market players to expect that other profitable projects could be underway. This may serve to increase the stock price of acompany.
The capital budgeting processes employed by a management may indicate the extent to which the management embraces shareholder wealth maximization and its commitment to the pursuit of that goal. This is extremely important to both shareholders and analysts and may influence company valuation and share price.
Question
What kind of effect is a project with a positive NPV expected to have on the value of a company and its share price?
A. Positive
B. Negative
C. Neutral
Solution
The correct answer is A.
Projects with a positive NPV are theoretically expected to increase the value of a company as well as the value of its stock.
Reading 32 LOS 32g:
Describe expected relations among an investment’s NPV, company value, and share price
Sergio Torrico
2021-07-23
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2021-07-17
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2021-07-16
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