ITPEC FE Morning April 2019 Question 79
Which of the following is a method for making decisions on the basis of the sum of the future cashflows discounted by a discount rate?
Explanation
Net Present Value (NPV) — it converts every future cash flow to today's value with the discount rate and adds them up.
A cash flow Ct received t years from now is worth Ct ÷ (1 + r)t today at discount rate r. NPV is the sum of these present values minus the initial investment. If NPV is positive the investment earns more than the discount rate and is accepted; between alternatives, the larger NPV wins.
Answer (b)
Why not others:
- •(a) IRR — also discounts cash flows, but solves for the rate that makes NPV zero and compares that rate with the required return; the decision rests on a rate, not on a sum
- •(c) PBP — counts the years until the cash inflows recover the initial investment; in its usual form the flows are not discounted and those after the payback point are ignored
- •(d) ROI — profit divided by the amount invested, a ratio with no discounting of the time value of money
Key rule: Only NPV and IRR account for the time value of money: NPV answers how much value in today's money, IRR answers at what rate of return.
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