When evaluating a capital project using net present value, what discount rate should be used?

• A. Net present value uses a discount rate equal to the hurdle rate.
• B. Net present value uses a discount rate equal to inflation.
• C. Net present value ignores risk.
• D. Net present value equals payback period.

Answer: (A)

In capital budgeting, NPV discounts future cash flows at a rate that captures the opportunity cost of capital and the project’s risk—the hurdle rate. This rate sets the minimum return the firm requires to undertake the project, so using it as the discount rate aligns the value of the cash inflows with what could have been earned elsewhere. Inflation alone isn’t the rate you use, because it doesn’t reflect the required return for taking on risk; it’s about price levels, not the firm’s opportunity cost. Risk is embedded in the discount rate you choose; NPV does not ignore risk. And NPV is not the same as the payback period, which ignores the time value of money and overall profitability. Therefore, the appropriate discount rate is the hurdle rate.