An organization is considering implementing a new customer relationship management (CRM) system. The business case estimates a net present value (NPV) of $500,000 using a 10% discount rate. If the discount rate were increased to 12% due to higher perceived risk, what would be the MOST likely impact on the NPV?
- AThe NPV would decrease, making the project less attractive.
- BThe NPV would remain unchanged, as it's a fixed value.
- CThe NPV would become negative, regardless of the initial positive value.
- DThe NPV would increase, making the project more attractive.
Show answer & explanationAnswer & explanation
Correct answer: A. The NPV would decrease, making the project less attractive.
Net Present Value (NPV) is calculated by discounting future cash flows back to their present value using a discount rate. A higher discount rate means that future cash flows are valued less in today's terms. Therefore, increasing the discount rate will reduce the present value of future inflows and increase the present value of future outflows (if any), resulting in a lower overall NPV, making the project less financially attractive.
Why the other options are wrong
- B. NPV is highly sensitive to the discount rate; it is not a fixed value independent of the rate.
- C. While it could become negative, it's not guaranteed. The most likely impact is a decrease, whether it remains positive or turns negative depends on the specific cash flows.
- D. An increased discount rate reduces the present value of future cash flows, thus decreasing NPV.
Net Present Value (NPV)
A financial metric used in capital budgeting to estimate the profitability of an investment by discounting all future cash flows (both positive and negative) to their present value and summing them up.
- NPV > 0: Project is expected to be profitable.
- NPV < 0: Project is expected to result in a loss.
- NPV = 0: Project breaks even.
- Sensitive to the discount rate used.
Memory trick: NPV: Now Present Value, Discounted Decisions.