ACCA Financial Management (F9) Certification Practice Exam

What does Net Present Value (NPV) measure?

1. Current value of cash inflows only

2. Future value of cash outflows

3. Value of cash flows discounted by a rate of return

4. The average return over a project's lifespan

The correct answer is: Value of cash flows discounted by a rate of return

Net Present Value (NPV) is a financial metric used to evaluate the profitability of an investment or project. It measures the current value of cash flows that an investment is expected to generate in the future, discounted back to their present value using a specified discount rate. This discount rate often reflects the required rate of return or the cost of capital. The significance of NPV lies in its ability to incorporate both the timing and magnitude of cash flows, providing a comprehensive view of an investment's worth. By discounting future cash flows, NPV accounts for the time value of money—recognizing that a dollar received in the future is worth less than a dollar received today due to factors such as inflation and opportunity cost. In contrast, the other options provide a limited or incorrect view of what NPV encompasses. For instance, focusing on current or future values of cash flows without the aspect of discounting misses the core principle behind NPV. Understanding cash flows in isolation, without considering the discounting process, would not provide an accurate measure of an investment’s profitability. Thus, recognizing that NPV represents the discounted value of future cash flows at a specified rate of return encapsulates its purpose and use in financial decision-making.