Net present value (NPV) analysis

Net present value (NPV) analysis

• A. Ignores inflation and uses nominal cash flows
• B. Measures profitability as a percentage of investment
• C. Accounts for inflation; suitable for long-term projects; reflects change in wealth
• D. Used only for short-term projects

Answer: (C)

Net present value analysis is all about the time value of money. By discounting future cash flows back to their present value, NPV shows how much wealth a project would add (or destroy) today. Inflation matters because it affects purchasing power over time, and NPV can account for this by using nominal cash flows with a nominal discount rate (or real cash flows with a real rate). This makes the method particularly meaningful for long-term projects, where the impact of discounting compounds and the project’s future inflows and outflows are spread over many years. A positive NPV means the project earns more than the required return and increases wealth; a negative NPV means it would reduce wealth. The other ideas don’t fit as well: inflation isn’t ignored—NPV can reflect inflation; it doesn’t express profitability as a percentage (that would be a return measure or profitability index); and it’s not limited to short-term projects, as it’s especially useful for evaluating long horizons.

Net present value analysis is all about the time value of money. By discounting future cash flows back to their present value, NPV shows how much wealth a project would add (or destroy) today. Inflation matters because it affects purchasing power over time, and NPV can account for this by using nominal cash flows with a nominal discount rate (or real cash flows with a real rate). This makes the method particularly meaningful for long-term projects, where the impact of discounting compounds and the project’s future inflows and outflows are spread over many years. A positive NPV means the project earns more than the required return and increases wealth; a negative NPV means it would reduce wealth.

The other ideas don’t fit as well: inflation isn’t ignored—NPV can reflect inflation; it doesn’t express profitability as a percentage (that would be a return measure or profitability index); and it’s not limited to short-term projects, as it’s especially useful for evaluating long horizons.