Question

The primary idea behind the net present value rule is that an investment:

A) Is worthwhile if it creates value for the owners.
B) Must have total cash flows that equal zero.
C) Should be accepted if it enhances management's position.
D) Should break-even from an accounting point of view.
E) Should earn a rate of return that is less than the discount rate.

Answer 1

The primary idea behind the net present value rule is that an investment is worthwhile if it generates a positive NPV, thus creating value for the owners by indicating future cash flows exceed the present investment cost.

Step-by-step explanation:

The primary idea behind the net present value (NPV) rule is that an investment is worthwhile if it creates value for the owners. This is because NPV measures the profitability of an investment by comparing the present value of an investment's future cash flows to the initial investment cost.

If the NPV is positive, it indicates that the discounted future cash flows from the investment exceed the initial outlay, therefore creating value for the owners. Conversely, an NPV that is negative suggests the investment would result in a net loss.

For instance, when a business contemplates a capital investment, the NPV calculation will help them determine whether the future benefits outweigh the present costs.

As such, it involves discounting future cash flows back to their present value using a discount rate, which typically reflects the cost of capital or required rate of return.

This method is also applied in various other scenarios, such as government decisions on infrastructure or environmental policy, as well as personal finance decisions like evaluating the lump-sum value of lottery payments over time.