Question need explanation Please

Submitted by Ux_PMP on Wed, 04/13/2011 - 05:08

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. 1 year: $ 15,000
  2. 2 year: $ 125,000
  3. 3 year: $ 220,000

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?

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cuongpt

Mon, 04/18/2011 - 11:20

Project 1: NPV = 120/(1+0.05) + 120/(1+0.1) + 120/(1+ 0.15) = 327

Project 2: NPV = 15/(1+0.05) + 125/(1+0.1) + 220/(1+ 0.15) = 345

NPV of project 2 is greater than project 1's one. So answer is C

Pls correct me if I'm wrong.

 

aaron

Mon, 04/25/2011 - 14:39

1st project NPV = 120/1.05 + 120/(1.05*1.05) + 120/(1.05*1.05*1.05) = 327

2nd project NPV = 15/1.05 + 125/(1.05*1.05) + 220/(1.05*1.05*1.05) = 317

1st project's NPV is approx 3% more than 2nd project.

Correct answer is A.

 

niteshrs

Mon, 05/16/2011 - 07:41

Check out the explanation also well given in the related post


http://pmzilla.com/net-present-values-questions-pmp


A better explanation to NPV sharing as below:


Net Present Value (NPV) measures the viability of a project or investment by taking into account the investments (outflow) and returns generated (inflow) from the investments. It is computed based on the sum of a series of cash flows in and out. NPV takes into account the series of cash paid or received in today’s value. This is different from a layman calculation of cash flows which only takes into account the dollar value of the cash flows. For example, we take out $1000 from our pockets to invest in a business venture. In one year’s time, the business venture pays out $1,100 and we put this money into our pocket.


To a layman, the net investment gain is $100 ($1,100 - $1,000). Using NPV, the amount is smaller. This is because we take into account what our initial $1,000 would have earned us if we put it in the bank. Assuming that the interest rate is 5%, our $1,000 would have earned us $1,050. Therefore the net investment gained would have been $50 ($1,100 - $1,050). That’s not all. The amount of $50 is what we would have gained in one year’s time. But in today’s time, that $50 would have worth less today. That means if we put less than $50 into the bank, we would have gotten that $50 in one year’s time. The exact amount is $47.62($50 / 105%). This amount is the Net Present Value of our cash out flow of $1,000 (denoted by a negative sign) plus a cash inflow of $1,100 in one year’s time (denoted by a positive sign).


Sounds complicated? Here’s another way of looking at it. That $1,100 in one year would have a present value of $1,047.62 ($1,100 / 105%). Since we took out $1,000 to gain that $1,100 (which has a present value of $1,047.62), the NPV is $47.62.