NPV Calculation

Submitted by kmkan28 on Thu, 03/14/2013 - 14:53

you are the project manager working on contract for an upscale retail toy shop.Your project invloves implementing a party event planner department in stores in 15 locations across the country as a pilot to determine if this will be a profitable new service all the stores should offer.You have identified two alternatives methods of implementing the pilot.Alternative A's initial investment equals $596,000.The PV of the expected cash flows is $299,000 in year 1 and $301,000 in year 2.The cost of capital is 14 percent.
Alternative B's initial investment equals $625,000.The PV of the Alternative B' expected cash flows is $321,000 in year 1 and $301,000 in year 2.The cost of capital is 10%
Which of the follwing is true?

A.Alternative A will earn a return of atleast 14 percent
B.Alternative B will earn a return of at least 10 percent
C.The return is not known for either Alternative A or Alternative B
D.Both alternative are viable choices

 

Please try for the above one and i have taken this one from a QBank.

 

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AP

Thu, 03/14/2013 - 17:57

My analysis is (assuming cash flows mentioned in the question is inflow),


Activity A


PV for 1st year = 299,000


PV for 2nd year = 301,000


NPV = Total Benefits - Cost = (299,000 + 301,000) - 596,000 = 4000


Activity B


PV for 1st year = 321,000


PV for 2nd year = 301,000


NPV = (321,000 + 301,000) - 625,000 = -3000


Hence answer should be (A) Alternative A will earn a return of atleast 14 percent
Explanation is, the 14% cost of capital for activity A would have been taken into consideration when the PV was calcutaed. When we get a NPV as a +ve value, it means we are getting a return of atleast 14%.


Please let me know if I'm wrong.


 


Regards,


Arun.

bkthakkar

Thu, 03/14/2013 - 21:13

 

details   Year
  0 1 2
project A   -596000    
PV     299000 301000
cost of capital 10%      
factor     0.91 0.83
Future Value   -596000 328571 362651
IRR 10.30%      
         
Project B   -625000    
PV     321000 301000
cost of capital 14%      
factor     0.88 0.77
Future Value   -625000 340860 391180
IRR 10.95%      

From the above  calculation, project B wlll have atleast 10%, the answer is B

Regards

Bhavesh

 

 

AP

Thu, 03/14/2013 - 21:46

Dear Bhavesh,

From your explanation, it seems there is lot of maths involved in this question. I noticed that you have interchanged the cost of capital for both the projects in ur calculation. Is this correct?

 

Regards,

Arun.

kmkan28

Fri, 03/15/2013 - 05:25

 thanks arun for your explanation

sspawar

Fri, 03/15/2013 - 00:00

 I agree with Mr. Arun's Answer and Explanation.

Expected cash flow = net flow, if positive means profit, if negative means loss.

in both cases, cash flow valurs for both the years is individually  +ve means in flows are net  and positive for respective years. (it is not only gross in flow niether gross out flow --- it is net flow).

in case A saving ( NPV) is 4000, means IRR is higher than cost of capital (discount rate)(opportunity cost of capital)

hence case A will earn atleast 14% return. --- option A

option B is will earn less than of 10%, because NPV is becoming -minus.

 

.

bkthakkar

Fri, 03/15/2013 - 00:42

Sorry guys, i

Inadvertently, cost of capital is interchanged.

But the calculation has to go in those lines.

IRR is the value  @ NPV = 0.

It is a matter of few min, nothing big deal on those calcuations

 

Bhavesh

 

sspawar

Fri, 03/15/2013 - 04:32

 yes Mr BHAVRSH

NPV =0 at IRR 

When discount rate bcomes such that Cash in flow in terms of PV  will be equal  to the Cash outflow in terms of PV.

That Discount rate will be termed as IRR.

Cash in flow in terms of PV  -  Cash outflow in terms  = NPV 

-------------------------

One correction in my previous reply

 

in case A saving ( NPV) is 4000, means IRR is higher than cost of capital (discount rate)(opportunity cost of capital)

 

in case A saving ( NPV) is 4000, means IRR (discount rate) is higher than cost of capital (opportunity cost of capital)

ref: http://maaw.info/IRRNPVandCostofCapital.htm

sunitaPMP

Fri, 03/15/2013 - 05:44

what is discount rate here?

sspawar

Fri, 03/15/2013 - 06:14

 it is not given but the the figures ( (299,000 + 301,000) and (321,000 + 301,000) or in terms of PV, it means these are obtained after operation of discount rate. Since NPV is larger than 0, in case of option A , means DR/ IRR will be greater than  cost of capital.

For exam point of view dont plung too much in this question.

AP

Fri, 03/15/2013 - 09:17

Dear Pawar,


Thanks for jumping in and clarifying things. I was wondering whether I was totally missing anything. But after your confirmation on this logic, I feel that I have understood this in the correct way. Thanks again!!!

Sangeetha.R

Fri, 03/15/2013 - 18:54

Do we get these types calculation sums for NPV, discounted rate , etc.,(project selection methods)? Please clarify.


To which do i need to prepare for this?

AP

Fri, 03/15/2013 - 19:26

As far as i have heard, we need to know the bascis atleast to answer the project selection method questions.

Sangeetha.R

Fri, 03/15/2013 - 19:43

To which level , should we need to prepare, I have gone through Rita on project selection methods.. is that fine?

AP

Fri, 03/15/2013 - 20:20

Yes, that is fine. But do know how to calculate PV, FV, NPV, and the concepts of IRR, discount rate. If you know all these things, then the question mentioned in this topic should be easy to crack.