Question

The calculation that expresses the ratio of net cash inflows to net cash outflows produced by a financial contract is known as:

Select one:

a. net present value.

b. net profit.

c. internal rate of return.

d. rate of return.

Answer 1

The answer to this question is option d ) rate of return

Rate of return defines the ratio between net cash inflow to net cash outflow

Rate of return = {( net Cash Inflow - net cash outflow) / net cash outflow } x 100

this can also be understood as the return produced by initial investment over a period of time.

Explaination  

option a ) net present value

NPV or net present value is the difference between the present value of inflow of cash and present value of outflow of cash over a time period .  

formula

NPV = (cash flow / (1 + r)^t) - initial investment

r = required return or discount rate

t = number of time periods

option b) net profit

It is the final sum in a business which remains as the final profit for share holders and  management of a firm. It is the final amount which is left after paying all the operating expenses , interest , Taxes and preferred stock dividends but common stock dividends are yet to be paid out of it.  

hence , it is not a ratio but rather a sum which is left at the end for a business entity after meeting all the external obligations .

Option c ) Internal rate of return or IRR

It is the rate at which the net present value (NPV) of all cash flow of a project becomes zero (0).

formula

[CF1/(1+r)^t1] + [CF2/(1+r)^t2] +[CF3/(1+r)^t3] +.......... [CFn/(1+r)^tn] - CF0 (initial investment) = 0

where

CF = cashflow

t = time period

r = discount rate or rate of return  

the r at which the whole equation becomes zero is called internal rate of return or IRR .