Which technique calculates the annual percentage return given by a project?

Which technique calculates the annual percentage return given by a project?

• A. A discounted cash flow technique that calculates the annual percentage return given by a project.
• B. The discounted rate used to calculate Payback.
• C. The present value of all future cash outflows.
• D. The total expected cash outflows.

Answer: (A)

The idea being tested is using a discounted cash flow method to express the project’s profitability as an annual percentage return. That return is the internal rate of return, which is the discount rate that makes the net present value of all cash flows (inflows and outflows) equal to zero. In other words, IRR is the annualized rate of return you’d earn from the project if you could reinvest at that same rate. That’s why this option is the best fit: it directly yields the annual percentage return from the project’s cash flows. The other ideas don’t give a project return. The discounted rate used for Payback relates to how long it takes to recover the initial investment, not to the project’s overall rate of return. The present value of all future cash outflows measures how much you must invest, not the return you expect. The total expected cash outflows are simply costs, not a measure of profitability.

The idea being tested is using a discounted cash flow method to express the project’s profitability as an annual percentage return. That return is the internal rate of return, which is the discount rate that makes the net present value of all cash flows (inflows and outflows) equal to zero. In other words, IRR is the annualized rate of return you’d earn from the project if you could reinvest at that same rate. That’s why this option is the best fit: it directly yields the annual percentage return from the project’s cash flows.

The other ideas don’t give a project return. The discounted rate used for Payback relates to how long it takes to recover the initial investment, not to the project’s overall rate of return. The present value of all future cash outflows measures how much you must invest, not the return you expect. The total expected cash outflows are simply costs, not a measure of profitability.