Question

Which of the following statements about capital budgeting decision-making is correct?

A. A firm should never undertake an investment if accepting the project would lead to an increase of the firm's cost of capital.
B. The primary reason for a negative NPV is that managers have done a bad job of estimating the NPV.
C. Firms should invest in positive NPV projects because they are riskier and have higher returns.
D. Positive NPV projects create value by having a return on investment greater than the cost of capital.

Answer 1

The correct statement is D: Positive NPV projects create value by having a return on investment greater than the cost of capital, which means that they are expected to generate more earnings than costs.

Step-by-step explanation:

The correct statement about capital budgeting decision-making is: D. Positive NPV projects create value by having a return on investment greater than the cost of capital. This is because positive Net Present Value (NPV) indicates that the expected earnings generated by a project or investment - in present dollars - exceeds the anticipated costs, also in present dollars. As such, firms should invest in these projects since they bring additional value.

It's important to note that a higher cost of capital does not categorically mean a firm should avoid an investment. The cost must be weighed against the potential returns. Similarly, a negative NPV does not always suggest that managers have estimated poorly; it could indicate that the project simply does not generate sufficient returns to justify the investment. Lastly, the desirability of a positive NPV project does not stem from being riskier, but rather from its ability to generate returns above the cost of capital.