Question 1

What is NPV and how is it calculated?

Accepted Answer

Net Present Value (NPV) is the sum of all future cash flows discounted back to today using a required rate of return (discount rate), minus the initial investment. NPV = Σ [Cash Flow_t ÷ (1 + r)^t] − Initial Investment. A positive NPV means the investment creates value above your required return. A negative NPV means the investment destroys value. NPV is the gold standard for capital budgeting because it accounts for the time value of money and the full magnitude of cash flows.

Question 2

What is IRR and how does it differ from NPV?

Accepted Answer

Internal Rate of Return (IRR) is the discount rate that makes NPV equal to zero — it is the effective annualized return of the investment. If IRR > your required rate of return (hurdle rate), the investment is worth pursuing. NPV tells you the dollar value created; IRR tells you the percentage return. NPV is generally preferred for capital allocation decisions because IRR can be misleading for projects with unconventional cash flows (multiple sign changes) or when comparing projects of different sizes.

Question 3

What discount rate should I use for NPV?

Accepted Answer

The discount rate should reflect the opportunity cost of capital — what you could earn on an alternative investment of similar risk. Common choices: 10% for stock market alternatives (historical S&P 500 average), 7–8% for real estate investments, 12–15% for venture capital, and your company's Weighted Average Cost of Capital (WACC) for corporate projects. A higher discount rate makes future cash flows worth less today and makes it harder for investments to show positive NPV. When in doubt, run sensitivity analysis at multiple discount rates.

Question 4

What is the profitability index (PI)?

Accepted Answer

Profitability Index (PI) = (NPV + Initial Investment) ÷ Initial Investment = Present Value of Future Cash Flows ÷ Initial Investment. A PI > 1.0 means the investment creates value (equivalent to positive NPV). PI is useful when you have capital constraints and need to rank multiple projects — choose projects with the highest PI first to maximize value per dollar invested. A PI of 1.25 means you get $1.25 in present value for every $1.00 invested.

Question 5

What is payback period and why does it matter?

Accepted Answer

Payback period is the time required to recover the initial investment from cumulative cash flows (undiscounted). It is a simple liquidity and risk measure — shorter payback means faster capital recovery and less exposure to long-term uncertainty. Most companies require payback within 2–5 years depending on industry. The limitation of payback period is that it ignores the time value of money and cash flows beyond the payback date. Discounted payback period (using present values) addresses the time value issue but is less commonly used.

Year	Cash Flow ($)	Present Value
0	−$100,000(initial)	−$100,000
1	$	$22,727.27
2	$	$24,793.39
3	$	$26,296.02
4	$	$27,320.54
5	$	$27,941.46

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