What is one advantage of NPV as a capital budget method? a.) It is more useful than IRR analysis when evaluating the efficiency of an investment. b.) It is reliable because all NPV calculations use the same discount rate. c.) It is a useful tool for comparing multiple investment options regardless of the duration of each. d.) Most companies can rely on NPV analysis alone when making investment choices.
The Correct Answer and Explanation is:
The correct answer is c) It is a useful tool for comparing multiple investment options regardless of the duration of each.
Explanation:
Net Present Value (NPV) is a widely used method in capital budgeting for evaluating the profitability of an investment. It calculates the difference between the present value of cash inflows and the present value of cash outflows over a specified period. The key advantage of NPV lies in its ability to assess investments with different time horizons (durations) on an equal footing.
Here’s why the other options are less accurate:
- a) It is more useful than IRR analysis when evaluating the efficiency of an investment:
This statement is not entirely true. While NPV is a reliable method, it doesn’t necessarily make it more useful than Internal Rate of Return (IRR) in all scenarios. IRR is often preferred when evaluating the rate of return at which an investment breaks even. However, NPV provides a dollar value that directly reflects the value added by an investment. - b) It is reliable because all NPV calculations use the same discount rate:
This is a bit misleading because the reliability of NPV does not stem from using the same discount rate. In fact, the chosen discount rate can significantly impact the NPV outcome, and it is critical to select a rate that reflects the cost of capital or expected return rate. Different rates can lead to vastly different NPVs. - d) Most companies can rely on NPV analysis alone when making investment choices:
While NPV is a valuable tool, it should not be relied upon exclusively. Other factors like risk, market conditions, and strategic alignment with company goals should also be considered. Using just NPV might oversimplify complex investment decisions.
Thus, option c is the best answer because NPV can be compared across projects of varying durations, making it highly useful when evaluating multiple investment opportunities.
