Practice Problem – NPV and Discount Rate

Practice Question

Intro to Finance
Capital Budgeting
NPV
MCQ

If the required rate of return changes from 15% to 7%, then the following would be true:

1. NPV increases
2. IRR decreases
3. Profitability Index decreases
4. Discounted payback period decreases
5. Wealth of investor decreases

Select one:

A) 1, 4
B) 1, 2, 4
C) 1, 2, 3, 4, 5
D) 2, 3, 4
E) 1, 2

Answer +
Correct Answer: A) 1, 4
Explanation +
1. NPV Increases

A lower required rate of return (discount rate) increases the present value of future cash flows. As a result, the NPV rises. ✔️ Correct.

2. IRR Decreases

IRR is independent of the required rate of return. It's the internal rate that makes NPV zero. So, IRR does not change when r changes. ❌ Incorrect.

3. Profitability Index Decreases

Since the present value of cash flows increases when the rate goes down, the PI (PV of inflows / initial investment) would increase, not decrease. ❌ Incorrect.

4. Discounted Payback Period Decreases

Lower discounting means higher present value per period. So, the discounted cash flows recover the initial investment sooner. ✔️ Correct.

5. Wealth of Investor Decreases

Since NPV increases, the investor's wealth (measured by project value creation) increases. ❌ Incorrect.

Conclusion

Only statements 1 and 4 are valid. Hence, the correct answer is: A) 1, 4.