Use the information below to answer the following question(s).Wet Water Company drills residential and commercial wells.The company is in the process of analyzing the purchase of a new drill.Information on the proposal is provided below:
Note: Other than the initial investment, cash flows are end of period.The working capital is returned at the end of the investment period.
-Which of the following is TRUE, concerning NPV?
A)When the NPV is positive, the sum of the cash flows from the project equal the initial investment.
B)When the NPV is negative, the sum of the cash flows from the project must also be negative.
C)The project just recovers the initial investment, discounted by the hurdle rate.
D)The IRR is less than the RRR when the NPV is positive, after using the RRR as the discount rate.
E)When the NPV is positive, the project recovers the initial investment and earns a return greater than the RRR.

Question

Use the information below to answer the following question(s).Wet Water Company drills residential and commercial wells.The company is in the process of analyzing the purchase of a new drill.Information on the proposal is provided below:
  Note: Other than the initial investment, cash flows are end of period.The working capital is returned at the end of the investment period.
-Which of the following is TRUE, concerning NPV?
A)When the NPV is positive, the sum of the cash flows from the project equal the initial investment. 
B)When the NPV is negative, the sum of the cash flows from the project must also be negative. 
C)The project just recovers the initial investment, discounted by the hurdle rate. 
D)The IRR is less than the RRR when the NPV is positive, after using the RRR as the discount rate. 
E)When the NPV is positive, the project recovers the initial investment and earns a return greater than the RRR.

Quizplus · Accepted Answer

When the NPV is positive, it means that the present value of the project's cash inflows exceeds the present value of its cash outflows, including the initial investment. Therefore, the project not only recovers the initial investment but also earns a return greater than the required rate of return (RRR), which is the opportunity cost of the investment. This is why the project is considered to be value-creating, and accepting it should increase the wealth of the company's shareholders. Conversely, when the NPV is negative, the project's cash outflows outweigh its cash inflows, and rejecting it should be preferred, as it destroys value. The IRR is the discount rate that makes the NPV equal to zero, and it represents the internal rate of return or the yield of the project. It is a useful tool to compare different investment opportunities, but it may not always provide a unique or reliable solution, especially if the cash flows are unconventional or non-periodic. The hurdle rate is another name for the RRR, and it reflects the minimum rate of return that the company expects to earn from its investments, given their risk and opportunity cost. Therefore, choice (E) is the best answer.

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