How is net present value (NPV) used to evaluate a project?

How is net present value (NPV) used to evaluate a project?

• A. NPV sums the present value of all expected cash flows minus the initial investment; positive NPV indicates value creation.
• B. NPV equals total cash inflows minus outflows.
• C. NPV is the discount rate that equates cash flows.
• D. NPV measures profitability ratio like ROE.

Answer: (A)

Net present value evaluates a project by discounting expected cash flows back to today and subtracting the initial investment. By using the cost of capital as the discount rate, NPV captures both how much cash is received and when it is received, reflecting the time value of money. A positive NPV means the project earns more than the required return and adds value to the firm, while a negative NPV indicates it would destroy value. This distinguishes it from simply inflows minus outflows, which ignores when those cash flows occur. It also isn’t the discount rate that makes cash flows equal (that’s the internal rate of return). And it isn’t a profitability ratio like ROE, since NPV is a dollar value, not a ratio.

Net present value evaluates a project by discounting expected cash flows back to today and subtracting the initial investment. By using the cost of capital as the discount rate, NPV captures both how much cash is received and when it is received, reflecting the time value of money. A positive NPV means the project earns more than the required return and adds value to the firm, while a negative NPV indicates it would destroy value.

This distinguishes it from simply inflows minus outflows, which ignores when those cash flows occur. It also isn’t the discount rate that makes cash flows equal (that’s the internal rate of return). And it isn’t a profitability ratio like ROE, since NPV is a dollar value, not a ratio.