CFA CFA Level 1 Can somebody explain me the meaning of these lines from CFA level 1 curriculum equity investments

Can somebody explain me the meaning of these lines from CFA level 1 curriculum equity investments

  • This topic has 5 replies, 5 voices, and was last updated Dec-17 by Pranav.
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  • mdrehan4
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    It’s example 4
     “How can poor information about the value of a project result in poor capital allocation decisions?
    Solution:
    Projects should be undertaken only if their value is greater than their cost. If investors have poor information and overestimate the value of a project in which its true value is less than its cost, a wealth-diminishing project may be undertaken. Alternatively, if investors have poor information and underestimate the value of a project in which its true value is greater than its cost, a wealth-enhancing project may not be undertaken.”
     

    christine
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    This is stressing the importance of being able to calculate and understand NPV and IRR properly. If this is estimated incorrectly (e.g. due to lack of information or expertise), one may mistakenly think e.g. Project A is a good idea (NPV>cost, or IRR positive), when this is not the actual case when the person/firm decides to undertake that investment.

    Does that make sense? I realise I’m just rewording this in a slightly different way so just shout if this is still confusing.

    mdrehan4
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    Thank you Christine, I got it but the confusion is with these sentences “a wealth-diminishing project may be undertaken” when NPV<cost and “a wealth-enhancing project may not be undertaken.” when NPV>cost.

    Anonymous
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    If true value is less than cost = NPV < cost = the project will lose the company money = wealth diminishing.

    So if investors have poor information and overestimate the value of the project (i.e. they think NPV >cost) then they erroneously decide to undertake the project, therefore losing money and diminishing wealth.

    And vice versa.

    TimBCanada
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    I’m seeing a lot of “if NPV < cost, this is bad” – that should really be “if NPV < 0”. Cost is already removed in the NPV equation, so saying NPV < cost just means you’re not doubling your money when taking TVM into account.

    Pranav
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    @mdrehan4‌ 
    “If investors have poor information and overestimate the value of a project in which its true value is less than its cost, a wealth-diminishing project may be undertaken.”

    true value is less than its cost ==> implies that NPV < cost; i.e. projects returns are less than investment, hence wealth will reduce, wealth-diminishing
    this is likely to happen when investor is not well-informed and ends up overestimating the value of the project, i.e. believes that returns will be more than the costs

    Alternatively, if investors have poor information and underestimate the value of a project in which its true value is greater than its cost, a wealth-enhancing project may not be undertaken.”

    true value greater than cost ==> implies that NPV > cost; i.e. projects returns are greater than investment and hence wealth-enhancing project
    but this project is not undertaken because investor is not well-informed and believes the projects returns to be less than the costs

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