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LOS f: Describe and account for the relative popularity of the various capital budgeting methods and explain the relation between NPV and company value and stock price.

Mollette Industries uses the payback period as its primary means for ranking capital projects. Which of the following most likely describes Mollette Industries with regard to location and management education?

U.S. based firm

Undergraduate degree or lower

European-based firm

Undergraduate degree or lower

European-based firm

MBA degree or higher

Despite the theoretical superiority of the NPV and IRR methods for determining and ranking project profitability, surveys of corporate managers show that a variety of methods are used. Firms that were most likely to use the payback period method were European firms and management teams with less education.

Garner Corporation is investing $30 million in new capital equipment. The present value of future after-tax cash flows generated by the equipment is estimated to be $50 million. Currently, Garner has a stock price of $28.00 per share with 8 million shares outstanding. Assuming that this project represents new information and is independent of other expectations about the company, what should the effect of the project be on the firm’s stock price?

A)	The stock price will increase to $34.25.

B)	The stock price will remain unchanged.

C)	The stock price will increase to $30.50.

In theory, a positive NPV project should provide an increase in the value of a firm's shares.

NPV of new capital equipment = $50 million - $30 million = $20 million
Value of company prior to equipment purchase = 8,000,000 × $28.00 = $224,000,000
Value of company after new equipment project = $224 million + $20 million = $244 million
Price per share after new equipment project = $244 million / 8 million = $30.50

Note that in reality, changes in stock prices result from changes in expectations more than changes in NPV.

Osborn Manufacturing uses the NPV and IRR methods as its primary tools for evaluating capital projects. Which of the following most likely describes Osborn Manufacturing with regard to firm ownership and company size?

Despite the theoretical superiority of the NPV and IRR methods for determining and ranking project profitability, surveys of corporate managers show that a variety of methods are used. Firms that use the NPV and IRR methods tend to be larger, publicly-traded, companies.

Which of the following firms is most likely to use a discounted cash flow technique as its primary capital budgeting tool?

A)	A large, publicly held European firm that has managers with no formal business education.

B)	A large, publicly held U.S. firm where managers that MBA degrees.

C)	A small, privately held European firm that has managers with no formal business education.

Companies that favor discounted cash flow capital budgeting techniques such as NPV and IRR over payback period or other non-DCF capital budgeting techniques tend to have the following characteristics:

Location: European firms tend to favor payback period.
Size: Smaller firms tend to favor payback period.
Ownership: Private firms tend to favor payback period.
Management education: The more highly educated a firm’s management, the more likely it is to use a DCF capital budgeting technique as its primary tool.