Lecture 7: Net Present Value Rule and Wealth Maximisation Notes

Possible Corporate Goals: Firms may choose from several objectives, including:
- Size maximisation.
- Customer satisfaction maximisation.
- Sales maximisation.
- Profits maximisation.
- Dividend growth maximisation.
The Primary Goal in Corporate Finance: The fundamental assumption is that the goal of a firm is to maximise shareholder wealth.
- Mechanism: Wealth maximisation is achieved by making decisions that specifically lead to the maximisation of the market price of the company’s shares.
- Stakeholder Considerations: This objective raises questions regarding other stakeholders, such as customers, suppliers, employees, and the government.
Wealth Maximisation and Society: Maximising shareholder wealth does not necessarily conflict with maximising stakeholder wealth.
- If product and labour markets function efficiently, maximising shareholder wealth provides the most benefit to society.
- Resource Allocation: Firms maximise wealth by allocating scarce resources to their most productive use. By doing so, they automatically respond to the needs of all stakeholders, including shareholders.

Microeconomic Perspective: Microeconomics typically views firms as choosing from a menu of production plans without an explicit time dimension.
Finance Perspective: Finance views firms as choosing from a menu of investment projects, all of which have explicit time dimensions.
Distinction: Profit maximisation may not always lead to wealth maximisation due to factors like timing and risk.

Foundational Question: What criterion should finance managers use to ensure their decisions lead to the maximisation of shareholder wealth?
The Answer: Under specific conditions, using the Net Present Value (NPV) rule maximises the share price and, by extension, shareholder wealth.
The Discounted Cash Flow (DCF) Approach: NPV is calculated by finding the Present Value ( $\text{PV}$ ) of future cash flows using the investors' required rate of return and subtracting the initial investment.
Standard Decision Rule:
- Accept the project if \text{NPV} > 0.
- Reject the project if \text{NPV} < 0.

Scenario: A property development firm is considering a proposal to build an out-of-town shopping centre.
Initial Investment: $\text{10m}$ .
Project Life: $4$ years.
Cash Flow Schedule:
- $t = 0$ : $-10$ (initial investment).
- $t = 1$ : $2$ .
- $t = 2$ : $7$ .
- $t = 3$ : $7$ .
- $t = 4$ : $7$ .
Required Return: Investors require a $20\%$ return.
Calculation:
- $\text{NPV} = -10 + \frac{2}{1.2} + \frac{7}{(1.2)^2} + \frac{7}{(1.2)^3} + \frac{7}{(1.2)^4}$
- $\text{NPV} = £3.95\text{m}$
Result: Since the \text{NPV} > 0, the firm should approve the proposal.

Theoretical Rationale: Formulated by Irving Fisher, the Separation Theorem states that if capital markets for borrowing and lending are well-functioning, companies can make investment decisions independently of the individual shareholders' consumption decisions by using the NPV rule.
The Perfect Capital Market (PCM) Condition: For Fisher’s Separation Theorem to hold, capital markets must be "perfect." Characteristics of a PCM include:
- Zero Frictions: No transaction costs. The interest rate for borrowing equals the interest rate for investing.
- Pure Competition: Access to markets is free and equal for all participants; no single participant can influence prices.
- Information Symmetry: All participants possess the same information regarding prices and firm/security characteristics.
- Competitive Pricing for Stakeholders: Other stakeholders face competitive prices.
- No Taxes: There are no distorting taxes.
Implications of PCM:
- Maximising share price makes shareholders better off because they can buy/sell shares or borrow/lend to reach their desired consumption-saving pattern.
- Market interest rates and returns represent the opportunity costs of transferring wealth across different time periods.
- By using market rates to calculate NPV, firms make the same trade-offs that investors make.

The Conflict: One common imperfection occurs when borrowing rates are significantly higher than saving rates.
- Impatient Investors: Those wishing to consume more than their current income will prefer a higher discount rate for NPV calculations.
- Patient Investors: Those wishing to save for the future will prefer a lower discount rate.
- The Dilemma: This creates a conflict for the finance manager on which rate to apply.
Resolution via PCM: In perfect markets, both types of investors want the firm to accept positive NPV projects because it increases their wealth.
- Impatient investors can borrow or sell shares to fund current consumption.
- Patient investors can lend or buy shares to fund future consumption.
- Conclusion: The manager can focus exclusively on one goal: finding and implementing positive NPV projects.

Project Profile:
- $t = 0$ : $-13,000$
- $t = 1$ : $3,000$
- $t = 2$ : $4,000$
- $t = 3$ : $4,000$
- $t = 4$ : $4,000$
- $t = 5$ : $6,000$
Required Rate of Return: $15\%$
Calculation:
- $\text{NPV} = -13000 + \frac{3000}{1.15} + \frac{4000}{(1.15)^2} + \frac{4000}{(1.15)^3} + \frac{4000}{(1.15)^4} + \frac{6000}{(1.15)^5}$
- $\text{NPV} = £533.4$
Impact on Firm Value: If the investment was not previously anticipated by the market, the market value of the firm’s equity capital will increase immediately by $£533.4$ upon learning of the project.

The "Once-for-All" Assumption: Conventional DCF-NPV assumes a "now-or-never" decision. In reality, managers have flexibility.
The Option to Delay: Managers may delay a project if they expect:
- A fall in interest rates.
- An increase in expected cash flows.
- New regulations that will affect the project beneficial way.
- Opportunity Cost: Conventional NPV ignores the opportunity cost of choosing to decide now rather than later.
Real Investment Options: Traditional NPV ignores the monetary value of managerial choices while a project is running, such as:
- Slowing down or expediting the project.
- Out-sourcing portions of the project.
- Expanding or stopping the project entirely.
Revised NPV Rule: To be truly consistent with wealth maximisation, the NPV rule must be revised to include the costs of lost future opportunities or the benefits of opportunities gained through real options. DCF is not the appropriate way to calculate NPV when real investment options are present.