NPV/ IRR rule Question on Qbank

CFA Level I Quant
#1

Dear all,

one question regarding a QBank question:

Which of the following statements regarding making investment decisions using NPV and IRR is least accurate?

A) If 2 projects are mutually exclusive, one should always choose the project with the highest IRR.

B) Projects with a positive NPV increase shareholder wealth.

C) If a firm undertakes a zero-NPV Project the firm will get larger , but shareholder wealth will not increase.

I understand very clear that answer A is wrong. However I do not agree with answer C to be fully correct. From my understanding a zero-NPV projects can not make a firm larger as it is simply changing money. The market value of the B/S of the firm sould be the same, or not? The book value of the B/S might even shrink, depending on the cash-flow pattern, making the company even smaller in the beginning.

Any thoughts on this?

Thanks and regards, Oscar

#2

It’s not the best question in the world.

Their point is that NPV measures the increase to shareholder value, so a project with an NPV of zero will not increase shareholder value (nor will it decrease shareholder value). However, because the firm will finance the project (through some combination of equity and debt), the value of the firm (as measured by total assets) will increase.

Sigh.

#3

A

I think you overthought the question.

I always think of NPV to do with increasing shareholder wealth

#4

It’s clear that the correct answer is A.

However, I think that C ist not stated 100% correct since the firm size will depend of the financing of the project. If it is 100% equity financed (cash) the company balance sheet will have the same size before and after the investment since it would be just an asset swap.

Only it there is some debt financing in place the balance sheet will increase on both sides increasing firm value/ enterprise value (even under a zero NPV scenario). Shareholder value/ equity value will be unchanged in any financing scenario on an zero NPV investment. (therefore A is the correct answer).

#5

This is not necessarily true. It could be 100% equity financed by issuing new stock, increasing equity and assets.

#6

A is wrong because a slightly lower IRR on a huge project is better than a higher IRR on a mini project… All about $Amt!

B is wrong because a positive NPV project may not return to the investors as much as anticipated. It’s a strong statement too…might not increase wealth 100% of the time as the question implies

Now why C is right… Remember that NPV is the number of cash flows DISCOUNTED AT THE IRR. The company still receives positive cash flow for the project… Just NPV is 0 after being discounted at a rate equal to what is required by shareholders.