Association for Financial Professionals (AFP) Practice Exam

When calculating the present value of cash flows, which rate is commonly used?

1. The weighted average cost of capital

2. The cost of capital as the markup rate

3. Opportunity cost as the discount rate

4. The minimum payback period as the number of periods

The correct answer is: Opportunity cost as the discount rate

The commonly used rate for calculating the present value of cash flows is the opportunity cost, which is applied as the discount rate. Opportunity cost represents the potential return on an investment that is forgone when allocating resources to a particular project instead of another. By using the opportunity cost as the discount rate, it allows for a more realistic assessment of the value of future cash flows, taking into account what could be gained from alternative investments. This approach helps in evaluating investments by enabling decision-makers to compare the present value of expected cash flows against the cost of capital or other investment opportunities. It reflects the underlying principle of time value of money, which states that a dollar received in the future is worth less than a dollar received today due to the potential earning capacity of that dollar. In contrast, the other options do not fit as well as a common rate for this calculation. For instance, while the weighted average cost of capital is important for evaluating investment decisions, it often does not reflect the true opportunity cost unique to specific cash flows. Similarly, using the cost of capital as the markup rate may not accurately reflect the potential returns of alternative investments. Lastly, the minimum payback period is not a rate but rather a time frame, which does not factor into the calculation of