Practice Question
Which of the following statements is most correct concerning a project with normal cash flows (i.e., a cash outflow in Year 0 followed by cash inflows in all subsequent years)?
A) If the NPV of a project is positive, then the payback period rule will always reject the project
B) If the NPV of a project is negative, then the profitability index of the project will always be greater than one.
C) If the PI of a project is greater than one, then the IRR will always be less than the project’s cost of capital
D) If the NPV of a project is zero, then the IRR of the project will be equal to the discount rate for the project.
Explanation:
- A) Incorrect. A positive NPV does not imply automatic rejection by the payback rule; however, the payback rule doesn’t consider time value of money and may differ in decision.
- B) Incorrect. A negative NPV implies PI < 1, since PI = Present Value of inflows / Initial outlay.
- C) Incorrect. If PI > 1, it generally means the IRR is greater than the discount rate (cost of capital), not less.
- D) Correct. By definition, the IRR is the rate that sets NPV to zero. So when NPV = 0, the IRR equals the project's discount rate.
Conclusion: D is the most correct statement under standard capital budgeting assumptions.