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Expected Monetary Value
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Posted 14 January 2014 - 04:59 AM
Hello - I have just started taking some mock tests for my PMP exams prep, came across this question, while the test paper had the right choice at the end, it did not have the approach. Can someone help me with this?
A company has to make a choice between two projects, because the available resources in money and kind are not sufficient to run both at the same time. Each project would take 9 months and would cost $250,000.
The first project is a process optimization which would result in a cost reduction of $120,000 per year. This benefit would be achieved immediately after the end of the project.
The second project would be the development of a new product which could produce the following net profits after the end of the project:
1. year: $15,000
2. year: $125,000
3. year: $220,000
Assumed is a discount rate of 5% per year. Looking at the present values of the benefits of these projects in the first 3 years, what is true?
1.Both projects are equally attractive.
2.The first project is more attractive by app. 7%.
3.The second project is more attractive by app. 5%.
4.The first project is more attractive by app. 3%.
Posted 24 March 2014 - 02:55 AM
It is a simple NPV calculation (future cash flow actualization).
First project benefit for the first 3 years are $120,000 ; $120,000 ; $120,000
So its NPV assuming a discount rate of 5% is 120,000/1.05+120,000/1.05^2+120,000/1.05^3=326,789 which gives a return of 326,789/250,000 = 30.7%
Second project benefit for the first 3 years are $15,000 ; $125,000 ; $220,000
So its NPV assuming a discount rate of 5% is 15,000/1.05+125,000/1.05^2+220,000/1.05^3=317,708 which gives a return of 317,708/250,000 = 27.1%
Correct answer is 4. The first project is more attractive by app. 3%.
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