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In: Finance

The relationship between a Net Present Value (NPV) and a discount rate could best be described...

The relationship between a Net Present Value (NPV) and a discount rate could best be described as?

Direct

Random

Stochastic

Indirect

Indeterminant

Solutions

Expert Solution

Direct

Explanation:

Their is a direct relationship between NPV and discount rate. They are inversely related to each other which means if discount rate is more NPV will be less and vice versa.

NPV is value of an investment today after considering the time value of money. So if the interest rate (discounting rate) is higher, it means that I need to invest less today to get the same amount that I could get by investing more at lower interest rates.

Let us take an example. Suppose you will get a cash inflow of $1000 after 1 year from now. In the first case, assume interest rate is 10% p.a. That means that you need to invest $909 today to get $1000 after 1 year. That is the NPV in this case. But if interest rates fall, you would need to invest more to get the same $1000 after 1 year. Assuming that interest rate is 8%p.a. instead of 10%, you will have to invest higher amount $925.93 now which is the NPV in this case.

Hence NPV has increased because time value of money has come down with fall in interest rates. When interest rates decline, the value today of your future benefits will have to go up so that you get those same future benefits that you crave for now.

jeff jeffy answered 2 years ago
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