Question

80. Which one of the following should be assumed about a project that requires a $100,000 investment at time zero, then returns S20,000 annually for 5 years? A. The NPV is negative. B. The NPV is zero. C. The profitability index is 1.0. D. The IRR is negative.

Answer 1

A.

option A is the answer

Reason :

The cost of the project is $100000 and without considering the time value of money the revenue/benefits to be received from the project would be exactly equal to $100000 ($20000*5) which means considering the effect of time value of money the revenue/benefits when discounted will be less than $100000.

The discounting may be assumed to be done at any rate, even 1% would make present value of revenue/benefits less than $100000.

NPV is the net present value = Present value of revenue/benefits - Present value of investment/ cost/ Outflows.

In the present case the present value of revenue/benefits falls below $100000 ( The Investment). Hence the NPV would be negative.

Why the other options are not correct :

B. NPV is not Zero since as explained above its negative

C. Profitability index = Present value of future cash inflows

Initial investment

Since the present value of future cash inflows are less than initial investment the profitability index would not be 1 and it would be less than 1.

D. IRR (Internal RateOf Return) is the rate at which the NPV ( Net Present Value ) of the project is ZERO. IRR is the interest rate which is used to discount the cash flows so that the NPV is Zero. So IRR can never be negative.

NOTE: Time value of money - A Dollar earned today is of more value than a Dollar earned tomorrow.