NPV as a Capital Budgeting Evaluation Method

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 NVP, Company Value, and Share Price

If a company invests in a positive NPV project, the expectation is that shareholder wealth will be increased as well as the company’s stock value.

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 shares outstanding. The effect of a project’s NVP is, however, more complicated than this.

In reality, if an analyst learns that a company intends to undertake an investment, the impact of the investment on the company’s stock price will depend on whether or not the investment’s profitability is more or less than expected. For example, a company’s project may have a positive NPV, but if the project’s profitability is less than analysts expect it to be, then the company’s stock price might fall.

It is also possible that news of a project having a positive NPV sends a positive signal to the markets, causing market players to expect that other profitable projects may be underway. This may serve to increase the company’s stock price.

Management’s capital budgeting processes may indicate the extent to which management embraces the goal of shareholder wealth maximization and its effectiveness in pursuing that goal. This is extremely important to both shareholders and analysts and may influence company valuation and share price.

Question

A project with a positive NPV is usually expected to have what kind of effect on a company’s value 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.

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Describe expected relations among an investment’s NPV, company value, and share price

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