Ch. 11: How to Ensure that Projects Truly have Positive NPVs

Question 1

What is economic rents?

Answer 1

Economic rents refers to abnormal returns, where realized profits exceed the cost of capital.

The concept is also observed frequently in practice: e.g., high profits in green energy due to high demand, without costs increasing simultaneously and proportionally

Question 2

NPV of an investment is the discounted value of the economic rents that it will produce. That is, if the NPV is positive, it only makes sense to invest if you have a competitive advantage (ability to generate economic rents).

True/ False

Answer 2

True

Question 3

Why is it important that managers have a clear understanding of their firm’s competitive advantage from the POV of Corporate Finance?

Answer 3

This allows managers to better identify the source of economic rents, and to better be able to separate truly positive NPV projects from negative NPV projects due to knowledge.

Decreases the risk of estimation errors in cash flow forecasts since they have better knowledge of what they are good at

Question 4

Disruptive innovation describes innovation that create new markets by discovering new categories of customers. This is done partly by harnessing new technologies but also by developing new business models and exploiting old technologies in new ways

True/ False

Answer 4

True

Question 5

What is sustained innovation?

Answer 5

Improvement of existing products

Question 6

NPV of an investment is the discounted value of the economic rents that it will produce

True/ False

Answer 6

True

Question 7

A positive NPV for a new project is only credible if it is likely that company has a ____ _____

Answer 7

competitive advantage

Question 8

Which of the following are examples of agency problems that can interfere with value-maximizing capital budgeting decisions? (Select multiple)
A) Reduced effort by managers
B) private benefits leading to managers spending money non non-value-adding investments (private jet)
C) Empire building
D) Entrenching investments in a manner that makes the manager’s skills “irreplaceable”
E) overinvestment and accepting projects with negative NPVs (due to FCF problem)
F) Insufficient disinvestment: avoiding to downsize when advantageous

Answer 8

All options are true

Question 9

The resulting cost from agency problems is termed _____

Answer 9

Agency costs

Question 10

How can a firm reduce agency costs related to investment decisions?
A) Constraints: law and regulation on managers’ actions
B) Monitoring and controlling managers’ effort and actions
C) Incentives (e.g., interest-aligning compensation schemes packages)
D) Self-enforcing contracts

Answer 10

A) Constraints: law and regulation on managers’ actions
B) Monitoring and controlling managers’ effort and actions
C) Incentives (e.g., interest-aligning compensation schemes packages)

WRONG:
D) Self-enforcing contracts

Question 11

What is the main problem with reducing agency problems through monitoring?

Hint: 2 reasons

Answer 11

1) It is costly (time, effort and money)
2) Difficult for the less informed party to monitor and control the more informed party

Question 12

Who does the monitoring? (Select multiple)
A) Shareholders
B) Board of Directors
C) Independent accountants (auditors)
D) Lenders
E) The market for corporate control

Answer 12

All are true