American Institute of Certified Planners (AICP) Practice Exam

Which method is used to analyze the profitability of an investment or project by evaluating future cash inflows?

1. Return on Investment

2. Net Present Value

3. Internal Rate of Return

4. Cost Benefit Analysis

The correct answer is: Net Present Value

Net Present Value (NPV) is a method that assesses the profitability of an investment or project by determining the value of future cash inflows in relation to current expenditures. The NPV calculates the difference between the present value of cash inflows generated by the investment over time and the present value of cash outflows required for the investment. The fundamental concept behind NPV is that money available now is worth more than the same amount in the future due to its potential earning capacity, which incorporates the time value of money. By discounting future cash inflows to their present values and subtracting the initial investment cost, NPV provides a clear picture of the project's profitability. A positive NPV indicates that the investment is expected to generate more value than its cost, while a negative NPV suggests the opposite. Other options like Return on Investment typically focus on a simple ratio of gains to costs without considering the time value of money. The Internal Rate of Return is related but expresses the discount rate at which NPV equals zero, highlighting the expected return rather than quantifying absolute profitability. Cost-Benefit Analysis compares costs and benefits in a straightforward way, but not necessarily in present value terms over time.