Net Present Value
Please answer each of the following questions. Each solution should be accompanied by a brief explanation of no more than two (2) typed lines in length.
A) Cynthia is the Chief Financial Officer of Big Corporation (BC). Cynthia’s current objective is to evaluate five new projects with a total capital requirement of $6 million. All of the projects have a positive NPV. The overall capital available for new projects for the next year is $5 million. Which of the following statements about the capital budgeting process that Cynthia should employ is true?
1) Cynthia should rank the projects in increasing order of NPV and choose the highest ranked projects in order until the capital available is exhausted.
2) Cynthia should rank the projects in increasing order of internal rate of return and choose the highest ranked projects in order until the capital available is exhausted.
3) Cynthia should calculate the NPV of various combinations of projects and choose that combination that provides the highest NPV without exceeding the capital available.
4) Cynthia should rank the projects in decreasing order of NPV and choose the highest ranked projects in order until the capital available is exhausted.
Explanation: Calculating combinations of different projects will give Cynthia a better idea in which projects to invest in. NPV also provides proper rule for choosing mutually exclusive projects
B) Which of the following statements about diversification is false?
1) Diversification can be accomplished by adding a stock that is perfectly positively correlated with the investor’s existing stock portfolio.
2) As the number of stocks in the portfolio increases, the diversifiable risk of the portfolio reduces.
3) When stock returns do not move perfectly with each other, the variations in the returns on one stock may be countered by variations in other stocks’ returns.
4) A perfectly diversified portfolio will still have risk equal to