Introduction to Corporate Finance

PART 3: CAPITAL BUDGETING

NPV and Share Price

The same forces that drove up the bond’s price in the previous section will drive up a company’s share

price when it makes a positive NPV investment, as shown in Figure 9.2. The figure depicts a company

that investors believe will pay an annual dividend of $4 in perpetuity. If investors require a 10% return

on this company’s shares, the price will be $40.^5 What happens if the company makes a new investment

that is as risky as the shares just described? If the return on this investment is greater than 10%, then

it will have a positive NPV. Investors will recognise that the company has made an investment that

exceeds their expectations and so will raise their forecast of future dividends, perhaps to $4.10 per year.

At that level, the new share price will be $41. The same thing happens in reverse if the company makes

an investment that earns a return below 10%. At this rate, the project has a negative NPV. Shareholders

recognise that this investment’s cash flows fall below their expectations, so they lower their estimates of

future dividends to $3.90 per year. As a consequence, the share price falls to $39.

Now apply this thought process to Global Untethered. Suppose that its shareholders demand an

18% return on their shares. According to the principles we discussed in Chapter 5, the price of Global

Untethered shares will reflect the value of all future cash distributions that investors expect from the

company, discounted at a rate of 18%. But what if Global Untethered discovers that it can make an

investment that offers a return substantially above 18%? By definition, such an investment has a positive

NPV; by undertaking it, Global Untethered will increase its share price (just as PMI Gold did; see page 308)

as investors realise that the investment will enable the company to distribute higher-than-expected cash

flows as a result of the investment. How far will the price of each share rise? Simply divide the project’s

NPV (which represents the wealth the project is expected to create) by the number of outstanding shares.

The result is the amount by which Global Untethered’s share price should increase.

FIGURE 9.2 THE NPV RULE AND SHAREHOLDER WEALTH

If a company invests in a project that earns more than its required return, its expected dividends and share price are expected

to rise. If the project earns less than the required return, the expected dividends and share price are expected to fall.

NPV $0

Project’s return  10%

Expected dividends $4.10

NPV  $0

Project’s return  10%

Expected dividends $3.90

price 

$4.00

 $40

0.10

Good investment

Bad investment

New share price

$4.10

 $41

0.10

New share price $3.90 $39

0.10

r  10%

Expected dividends  $4.00

Current share

Chris Muscarella,

Professor of Finance and

L.W. ‘Roy’ and Mary Lois

Clark Teaching Fellow,

Pennsylvania State

University

‘We look at the impact

on stock prices of

firms’ capital budgeting

decisions.’

See the entire interview on

the CourseMate website.

COURSEMATE
SMART VIDEO

Source: Cengage Learning

5 Remember that the price of a share that pays a constant dividend in perpetuity equals the annual dividend divided by the required rate of

return – in this case, $4 ÷ 0.10 = $40.