Corporate financeLesson 2 of 6 in the course How Companies Think about Investing

Net Present Value: Discounting, Decision Rules, and NPV Profiles

5 flashcards · 5 quiz questions · 5 match pairs · 5 fill-in sentences · English

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Summary

Net present value (NPV) helps a company decide whether an investment is expected to add value. This lesson explains how to compare cash flows that occur at different times by translating them into present dollars.

A project often requires an investment today in exchange for cash inflows in future years. Since a dollar received in the future is not equivalent to a dollar received today, the cash flows cannot be compared directly. The time value of money provides a way to express them in a common time period: present value.

All flashcards

Net present value (NPV)
The present value of a project's cash inflows minus the present value of its cash outflows.
Discounting a future cash flow
Divide the cash flow by (1+r)t(1+r)^t, where rr is the discount rate and tt is the number of periods until receipt.
NPV profile
A graph showing a project's NPV across a range of discount rates.
Internal rate of return (IRR)
The discount rate at which a project's NPV equals zero.
Opportunity cost in investment analysis
The value of resources sacrificed by choosing a project, such as wages forgone while studying.

Quiz questions

  1. What does the internal rate of return represent for a project?Answer: The discount rate at which the project's NPV equals zero.
  2. What limitation of NPV matters when a firm has limited funds and several projects have positive NPV?Answer: The NPV rule alone may not identify the best combination of projects to fund.
  3. For a project with future cash inflows, what generally happens to NPV when the discount rate rises, with cash-flow estimates unchanged?Answer: NPV generally declines because future inflows have lower present values.
  4. When evaluating the cost of pursuing a full-time degree, which item is an opportunity cost?Answer: Wages forgone while studying instead of working.
  5. What does a financial calculator not determine for an NPV analysis?Answer: Which cash flows and discount rate are appropriate for the project.

Based on Principles of Finance by Julie Dahlquist, Rainford Knight (OpenStax), licensed CC BY 4.0. Adapted into a summary, flashcards and quizzes.

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