Which of the following statements is correct?
A) Because initial cost is a sunk cost, we should not consider or include the initial cost when we calculate the net present value of the project.
B) When deciding which projects to accept, NPV is generally regarded as the best single criterion.
C) The NPV of a project measures the intrinsic value of the project.
D) Investors should require a higher NPV if the project has higher risk
The correct answer and explanation is:
The correct answer is B) When deciding which projects to accept, NPV is generally regarded as the best single criterion.
Explanation:
Net Present Value (NPV) is a widely used financial metric that helps assess the profitability of a project or investment. It calculates the difference between the present value of cash inflows (benefits) and the present value of cash outflows (costs), discounted by the project’s cost of capital. Here’s why B is correct and the others are not:
A) Because initial cost is a sunk cost, we should not consider or include the initial cost when we calculate the net present value of the project.
- This statement is incorrect. The initial cost of a project is not a sunk cost in the NPV calculation, as it represents an outlay that is part of the project’s total costs. While sunk costs (costs that have already been incurred and cannot be recovered) should not be included in the decision-making process, the initial cost of the project is a relevant outflow that must be included in NPV calculations.
B) When deciding which projects to accept, NPV is generally regarded as the best single criterion.
- This is the correct statement. NPV is considered one of the most reliable investment decision-making tools. It accounts for the time value of money and provides a direct estimate of the expected increase in value that the project will bring to the firm. Positive NPV indicates that the project is expected to create value, making it a top criterion for project acceptance.
C) The NPV of a project measures the intrinsic value of the project.
- This is misleading. While NPV measures the financial value a project is expected to create for investors, it doesn’t directly measure the “intrinsic value” in terms of non-financial factors like social or environmental impact. NPV is purely financial and focuses on the value that is generated through cash flows.
D) Investors should require a higher NPV if the project has higher risk.
- This statement is incorrect. Investors typically require a higher rate of return to compensate for higher risk, not a higher NPV. The required return (discount rate) will be higher for riskier projects, but the NPV itself is the result of the discounted cash flows. If the required rate of return increases due to higher risk, it may actually reduce the NPV.
NPV’s ability to incorporate the time value of money, its focus on cash flows, and its straightforward interpretation as a value-added measure make it a superior criterion for investment decisions.