______________ may be defined as the excess of present value of project cash inflows over that of out flows.
|A. Net present value technique.|
B. Average rate of return.
C. Benefit-Cost ratio.
D. Internal rate of return
The Correct Answer Is:
A. Net present value technique.
Net present value (NPV) is a financial metric used in capital budgeting to evaluate the profitability of an investment or project. It represents the difference between the present value of cash inflows and outflows over a specific period.
In other words, it calculates the net benefit or loss generated by an investment after accounting for the time value of money.
Here’s a detailed explanation of why option A, “Net present value technique,” is the correct answer:
A. Net Present Value Technique:
The Net Present Value (NPV) technique is a widely used financial method for evaluating the feasibility of an investment or project. It takes into account the time value of money, recognizing that a dollar received in the future is worth less than a dollar received today due to factors like inflation and the opportunity to earn a return on investment.
NPV is calculated by discounting all future cash flows (both inflows and outflows) to their present value and then subtracting the initial investment. If the resulting NPV is positive, it indicates that the project is expected to generate more cash than it consumes, making it potentially profitable.
Now, let’s explain why the other options are not correct:
B. Average Rate of Return:
The Average Rate of Return (ARR) is another investment appraisal method, but it does not account for the time value of money. It calculates the average annual profit or loss generated by an investment as a percentage of the initial investment.
ARR does not provide a clear indication of the project’s profitability over time, making it less accurate than NPV for assessing long-term investments. Unlike Net Present Value (NPV), which takes into account the time value of money, ARR is a simple accounting measure that does not consider the present value of cash flows.
C. Benefit-Cost Ratio:
The Benefit-Cost Ratio (BCR) compares the present value of benefits to the present value of costs. A BCR greater than 1 indicates that the benefits outweigh the costs, suggesting that the project is potentially viable.
However, it does not quantify the net monetary gain or loss, which limits its ability to provide a clear measure of the project’s profitability. This makes it less precise than the Net Present Value (NPV) technique for assessing the financial feasibility of an investment.
D. Internal Rate of Return:
The Internal Rate of Return (IRR) is the discount rate that makes the NPV of a project zero. It is essentially the interest rate at which the present value of cash inflows equals the present value of cash outflows.
While IRR is a valuable tool for assessing investment opportunities, it may not always provide a clear indication of the actual value generated by a project, especially when multiple potential projects are being compared.
In summary, the Net Present Value technique (Option A) is the most accurate and comprehensive method for evaluating the financial viability of a project, as it considers the time value of money and provides a clear measure of the net benefit or loss generated.
The other options, while useful in specific contexts, do not offer the same level of precision and holistic evaluation as NPV.