The Importance of Net Present Value in Investment Decisions

D

Sure, I'd be happy to explain the answer to this question in detail.

The net present value (NPV) is a measure of the present value of the expected future cash flows of an investment project, discounted at the required rate of return (usually the firm's cost of capital). If the NPV is positive, it means that the investment is expected to generate a return greater than the required rate of return, and it is therefore generally considered a good investment.

Option A suggests that the firm should calculate the internal rate of return (IRR) of the investment to be certain that the IRR is greater than the cost of capital. The IRR is the discount rate that makes the NPV of the investment equal to zero, and it represents the rate of return the firm can expect to earn on its investment. However, since the NPV of the investment is already greater than zero, calculating the IRR is not necessary to determine whether the investment is a good one. Therefore, option A is not the best answer.

Option B suggests that the firm should compare the profitability index (PI) of the investment to those of other possible investments. The PI is the ratio of the present value of the expected future cash flows to the initial investment. It is a useful measure to compare different investment opportunities, as it considers both the amount and timing of cash flows. However, since the NPV of the investment is already greater than zero, it means that the investment generates a positive return and therefore has a positive PI. Thus, comparing the PI to those of other possible investments is not necessary to determine whether the investment is a good one. Therefore, option B is not the best answer.

Option C suggests that the firm should calculate the payback period (PBP) to make certain that the initial cash outlay can be recovered within an appropriate period of time. The PBP is the amount of time it takes for the initial investment to be recovered from the expected cash flows of the investment. While the PBP is a useful measure to assess the liquidity of an investment, it does not consider the time value of money or the total expected cash flows of the investment. Therefore, it is not the best measure to determine whether an investment is a good one. Moreover, since the NPV of the investment is already greater than zero, it means that the investment generates a positive return and therefore has a positive NPV. Thus, calculating the PBP is not necessary to determine whether the investment is a good one. Therefore, option C is not the best answer.

Option D suggests that the firm should accept the proposal, since the acceptance of value-creating investments should increase shareholder wealth. This is the best answer, as a positive NPV implies that the investment is expected to generate a return greater than the required rate of return, and therefore increase shareholder wealth. Moreover, the fact that the firm is not under the constraint of capital rationing means that there are no limitations on the amount of capital available to invest in value-creating projects. Therefore, accepting the proposal is the best course of action for the firm.