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There are 2 projects with NPV, IRR, ROCE and PP as follow:
P1: NPV=1.1m , IRR=24%, ROCE=35% and PP= 2.5 years
P2: NPV= 1.5m, IRR=12%, ROCE= 18%, PP= 7 years
The objective of the company is to maximise shareholder wealth. Which project should be chosen?
The answer for this question is P2 because its NPV is higher than P1.
My question is when choosing a project to maximise shareholder wealth we should base on the ROCE and not the NPV because ROCE shows the return ( or profit) that the shareholders earn on the equity that they put in the company while the NPV only looks at the cash flows not the profit of the project. Consequently, i would chose P1 instead.
Thanks for your help in advance.
If you want me to answer, then in future you must ask in the Ask the Tutor Forum – this forum is for students to help each other.
Shareholders wealth is measured by the value of their shares. In theory (and for the exam), the market value of the shares is the present value of the future expected dividends discounted at their required rate of return.
The dividends that a company is able to pay each year are determined by the companies cash flows each year, not by the profits.The higher the NPV of any investments, the higher will be the market value of the shares and therefore the higher will be the shareholders wealth.
All of this is explained in my free lectures. The lectures are a complete free course for Paper F9 and cover everything needed to be able to pass the exam well.
Time 0, time 1, time 2 etc are called timing of cash flow. Time 0 is the start of first year, time 1 is the end of first year and start of second year, time 2 is the end of second year etc
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