What is the decision rule for NPV in capital budgeting?

What is the decision rule for NPV in capital budgeting?

• A. Accept if IRR > discount rate; reject if IRR < discount rate; indifferent if equal.
• B. Accept if NPV > 0; reject if NPV < 0; indifferent if NPV = 0.
• C. Accept if NPV < 0; reject if NPV > 0; indifferent if NPV = 0.
• D. Accept if payback period is less than 2 years; else reject.

Answer: (B)

When evaluating projects, the aim is to measure value creation by comparing the value of future cash inflows to the initial investment, using the firm's cost of capital as the rate to discount those inflows. The net present value (NPV) is the sum of all discounted future cash flows minus the amount invested up front. The correct rule is to accept a project if its NPV is positive, reject if NPV is negative, and be indifferent if NPV is zero. A positive NPV means the project earns more than the cost of capital, adding value to the firm. A negative NPV means it doesn’t cover the cost of capital, destroying value. If NPV is exactly zero, the project just meets the required return, leaving value unchanged. Other options mix in different criteria not tied to NPV. One uses the internal rate of return threshold, which is a different decision rule and can be ambiguous in some cases. Another uses payback period, which ignores the time value of money and cash flows after the payback, so it’s not the NPV criterion.

When evaluating projects, the aim is to measure value creation by comparing the value of future cash inflows to the initial investment, using the firm's cost of capital as the rate to discount those inflows. The net present value (NPV) is the sum of all discounted future cash flows minus the amount invested up front.

The correct rule is to accept a project if its NPV is positive, reject if NPV is negative, and be indifferent if NPV is zero. A positive NPV means the project earns more than the cost of capital, adding value to the firm. A negative NPV means it doesn’t cover the cost of capital, destroying value. If NPV is exactly zero, the project just meets the required return, leaving value unchanged.

Other options mix in different criteria not tied to NPV. One uses the internal rate of return threshold, which is a different decision rule and can be ambiguous in some cases. Another uses payback period, which ignores the time value of money and cash flows after the payback, so it’s not the NPV criterion.