Which concept is the rate that makes net present value zero?

Which concept is the rate that makes net present value zero?

• A. Internal rate of return.
• B. Net present value.
• C. Annuity.
• D. Cost of capital.

Answer: (A)

Internal rate of return is the discount rate that makes net present value equal to zero. In other words, it’s the rate at which the present value of the project’s future cash inflows exactly equals the initial investment. If you set the discount rate in the NPV formula to this value, the NPV becomes zero, which defines the break-even rate of return for the project. In practice, you compare this rate to your cost of capital: if the IRR is higher, the project should add value because it earns more than your financing cost. Keep in mind that with non-standard cash flows there can be multiple IRRs, and IRR implies reinvesting cash flows at the IRR, which may not always be realistic.

Internal rate of return is the discount rate that makes net present value equal to zero. In other words, it’s the rate at which the present value of the project’s future cash inflows exactly equals the initial investment. If you set the discount rate in the NPV formula to this value, the NPV becomes zero, which defines the break-even rate of return for the project. In practice, you compare this rate to your cost of capital: if the IRR is higher, the project should add value because it earns more than your financing cost. Keep in mind that with non-standard cash flows there can be multiple IRRs, and IRR implies reinvesting cash flows at the IRR, which may not always be realistic.