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ACCA Strategic Professional · Advanced Financial Management · Financial strategy formulation

Karamba Ltd's board is considering a project requiring investment now with a positive NPV of $2 million at the company's cost of capital, but which will reduce reported EPS for the next two years. In terms of the shareholder wealth objective, what should the board do?

The board should accept the project. A positive NPV at the appropriate cost of capital is expected to raise shareholder wealth, even if reported EPS falls for two years, because EPS ignores the timing and risk of cash flows and does not measure value creation.

  1. AReject it, because reported EPS will fall
  2. BAccept it, because a positive NPV at the cost of capital is expected to increase shareholder wealthCorrect
  3. CReject it, because projects must increase EPS in every year
  4. DAccept it only if the dividend is increased in the same period

Explanation

NPV measures the present value of the increase in shareholder wealth when discounted at a rate reflecting project risk. Short-term EPS reductions do not change this, provided the market understands the strategy. Dividend increases are not required for acceptance.

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