Question

When calculating Net Present Value for a field development project, what is the result if the discount rate is equal to the project&#x27;s internal rate of return?

Accepted Answer

When the discount rate used to calculate Net Present Value is equal to the project&#x27;s Internal Rate of Return, the resulting Net Present Value is exactly zero. To understand why, you must first understand the two components. Net Present Value is the total sum of all future cash flows generated by a project, adjusted for the time value of money by discounting them back to their value today. The discount rate is the interest rate used to perform this adjustment, representing the required rate of return or the cost of capital. The Internal Rate of Return is the specific discount rate that would cause the Net Present Value of a project to equal zero. Because the Internal Rate of Return is defined as the break-even interest rate where the present value of cash inflows equals the present value of cash outflows, setting your discount rate to this exact value mathematically forces the net result to zero. For example, if a project costs 100 dollars today and returns 110 dollars in one year, its Internal Rate of Return is 10 percent. If you calculate the Net Present Value using a 10 percent discount rate, the 110 dollars in the future is worth exactly 100 dollars today; subtracting the initial 100 dollar cost leaves you with a Net Present Value of zero.

Home → All Courses → Engineering and Technology Courses → Petroleum Geology, Hydrocarbon Exploration and Production, and Reservoir Evaluation → Flashcard

When calculating Net Present Value for a field development project, what is the result if the discount rate is equal to the project's internal rate of return?