l7 : NPV rule & wealth maximisation

Question 1

what is the goal of the firm?

Answer 1

maximise shareholder wealth

Question 2

what is maximising shareholder wealth?

Answer 2

when the firm maximises the market price of the company shares. if product and labour markets work efficiently, maximising shareholder wealth will benefit society the most. it is done by :
- firms allocating resources to their most productive use
- automatically respond to needs of other stakeholders

Question 3

what is the net present value (NPV) rule?

Answer 3

when a firm maximises share price therefore maximising shareholders wealth

Question 4

what is the decision rule when using the NPV rule?

Answer 4

if
NPV > 0, then accept
or
NPV < 0, then reject

Question 5

what is a perfect capital market (PCM)?

Answer 5

• no transaction costs or other barriers to accessing capital markets by firms or investors
• interest rate on borrowing equals the interest rate on investing
• markets are competitive, no participants have the power to influence prices
• all participants have same info about prices & security characteristics
• no distorting taxes

Question 6

what is fishers separation theorem?

Answer 6

in PCMs, firms choice of investment is separate from the owners investment preferences. all investors share same decisions about rejecting or accepting investment projects, as they base decisions on NPV rule. therefore, firm invests based on motivation to maximise profit for the firm. investors preferences have no weighting in the decision.

Question 7

what happens when capital markets are imperfect?

Answer 7

borrowing rates > saving rates, for example. could cause :
- impatient investors who wants to borrow and consume more than their income will want firm to use higher discount rate
- patient investors who want to save for future will want firm to use lower discount rate