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Npv Calculation Explanation With Examples
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Posted 24 June 2009 - 01:09 PM
I will be taking the PMP exam by the end of this month and need some clarification on below topics
NPV Calcuation to select the best project with example
an example question that i have trouble figuring out is
A company has to make a choice between two projects, because the available resources in money are not sufficient to run both at the same time. Each project would take 9 months and would cost $250000.
1. The first project is process optimization which would result in cost reduction of $120000 per year. This benefit would be acheived immediately after the end of the project.
2. The second project would be the development of new product which could produce the following net profits after the end of the projects:
1 year $15000
2 year $125000
3 year $220000
3. Assumed is a discount rate of 5% per year. Looking at the present values of these projects revenues in the first 3 years what is true
A. Both projects are equally attractive
B. The first project is more attractive by app 7%
C. The second project is more attractive by app 75%
D. The first project is more attractive by app 3%
I would really appreciate if anyone could show me in detail how to go about working on this problem?
Posted 27 June 2009 - 11:25 AM
Refer this URL,
Net Present Value (NPV). NPV is a capital budgeting technique that compares the projected cash flows to the costs of an investment. It uses the time value of money to evaluate these future cash flows at a particular point in time. If the NPV is less than zero, the solution should be rejected. A negative number signifies that the initial cash outlay will be more than what you can expect to receive in return. If the NPV is greater than or equal to zero and the solutions are of similar size and risk, you should select the one with the highest positive NPV.
NPV = ( Investment + Income ) of Curr. Value - ( Expense of Cuu. Value )
If you invest $100 at 7 percent interest for one year, you would receive $107.
FV = PV + PV x I
= PV ( 1 + I )
107 = 100 + (100 × .07)
The next year
FV = PV ( 1 + I ) + PV ( 1 + I ) X I
= PV ( 1 + I ) ( 1 + I )
= PV ( 1 + I )^2
In the Nth year
FV = PV ( 1 + I )^n
PV = FV / ( 1 + I )^n
Let us look at our example.
The cost and durationof Project 01 and Project 02 is same, So let us not worry abot the cost.
However let us look at the benefit.
Yr1 $ 120,000/(1+0.05)^1 = $ 114,286
Yr2 $ 120,000/(1+0.05)^2 = $ 108,844
Yr2 $ 120,000/(1+0.05)^3 = $ 103,661
Total $ 326,791
Yr1 $ 15,000/(1+0.05)^1 = $ 14,286
Yr2 $ 125,000/(1+0.05)^2 = $ 113,379
Yr2 $ 220,000/(1+0.05)^3 = $ 190,044
Total $ 317,709
From the above working it is obvious, project 01 is yeilding more than Project 02.
Therefore project 01 is the correct answer than Project 02.
Plan your Work and Work your plan.
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