Can anybody help me in solving the following questions.This question is the 2nd question from the Oliverlehmann's test questions.
Appreciate your help
Tue, 02/10/2009 - 13:35
Let's do it:
Costs for all projects are the same (250K), so you may let them out and focus on the present value (PV). (remember NPV = PV - investment?)
First project: Cost reduction of 120K/year starting IMMEDIATLY after project's end.
Second: After projec's end, the return will bu 15K for first year, 125K for second year and 220K for third year.
Discount rate is 5%.
Think of discount rate the rate your money will loose value (how much is worth if you lend one of your relatives US$ 5000,00 and get the same ammount back in 3 years?)
Formula for PV = FV / (1 + rate)^n (n = periods)
So 1s project:
120000 + 114286 + 108844 = 343130
15000 + 119048 + 199546 = 333594
rate = 0,05 and n will assume 0, 1, 2 according to first through 3rd year.
The first project is better than the second. But how much better?
If you calculate PV_project_A over PV_project_B you will find 1,029, telling you that project A is better than B by ALMOST 3%
There is a trick here, cause it does not say clearly if project's B return starts immediately after project's end.
You WON'T have to calculate PV on the test, but knowing how to do it provides you better understanding.
It's all about the real value of the money in the future.
Tue, 02/10/2009 - 17:03
Thanks a lot for your detailed explanation..
Appreciate your help.
Sun, 03/22/2020 - 18:04
The questions are valid. In fact, it is very well connected to real-world scenarios that is happening as it is. - Marla Ahlgrimm
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