Project Selection - NPV vs BCR vs IRR vs payback

Submitted by charnelle_beste... on Sun, 05/13/2012 - 19:18
 

The answer is Project A

Feedback and explanation to this would be greatly appreciated.

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saket_pmp

Mon, 05/14/2012 - 12:45

I cannot decide which to choose.


1. If the NPV calculation is greater than zero, accept the project. Project A has NPV 185,000. It’s good, but how would I say it’s the BEST?


2. Benefit Cost Ratio - It compares the cost to produce the product, service, or result of the project to the benefit. Project B of $1 million has  ration 1:6, good, but how would I say it’s the BEST?


3. IRR - Technically speaking, IRR is the discount rate when the present value of the cash inflows equals the original investment. 18% is good percentage i.e. in about 4 years you will get all cash invested.


4. The payback period is the length of time it takes the company to recoup the initial costs of producing the product, service, or result of the project. The payback period is the least precise of all the cash flow calculations. That’s because the payback period does not consider the value of the cash inflows made in later years, commonly called the time value of money.


With this said so, I cannot decide which project to choose, because I do not know which is the BEST i.e. how do I compare and with what the returns I am getting?


NPV and IRR will generally bring you to the same accept/reject conclusion. If you force me to choose any answer, I will go with NPV (A) or IRR (C) i.e. 18% which is a good number from growth perspective.
 

projmanpro

Mon, 05/14/2012 - 13:21

I totally agree with saket's point.

Though, as to the limitation of the info in the question (it is clear in the question that ...."based on this information") , so thinking about no further info beyond what is given in the question, only the project with a given pretty good NPV, is best to be selected, though C (IRR of 18%) could be correct too, but NPV is the best. Why? Because NPV is specified, while IRR though given the % but we cannot know how much is the capital and projected revenue; though this situation is as per the question ----"based on the given info" only and we cannot squeeze the question to give us the further required info he he he

saket_pmp

Mon, 05/14/2012 - 14:15

Ok, NPV has been specified, and the first impression for everyone would be, same i.e. choose it as it’s a fixed number (Quantitative data i.e. measurable).


In reality its not measurable data, lets see this way. With the business investment I am getting NPV as 185,000. I do not know anything else "Based on this information". Let’s take 2 case:
1. My investment was very big i.e. 18,500,000. In this case the amount 185,000 is just 1%
2. My investment was small say 185,000. I would be very happy to see NPV as 185,000, its like 100%.
This means the measurable value of NPV is actually un-measurable until we know how much was the investment amount. In short I cannot say NPV as 185,000 is good or not.


The next one IRR of 18%. This looks un-measurable, but in reality always gives a measurable data i.e. regardless of what amount I invest, I will always get 18% return. In the above 2 example it would be:
1. 18% of 18,500,000 = 3,330,000
2. 18% of 185,000 = 33,300
In both cases its measurable and always 18% profitable.


If we go by the above example, it should be the IRR when we do not know the investment amount. Any secondary thought now? Or it’s the same?

projmanpro

Tue, 05/15/2012 - 05:51

I think saket, you have misunderstood the logic. Your calculation showing the use of percentage e.g. IRR is not logically that way. If you are given an IRR %, it doesnt mean you have to multiply it with the principal or revenue. In general, likewise, you cannot say NPV represents a % of the principal.

Economics experts say, IRR can fool us, but ideally, u need an NPV curve to evaluate an investment.

Let me show a simple calculation.

NPV = 185,000
NPV = In/(1+r)^n, ; where I = Individual amount for each year (in the income stream, let us assume I = 100,000; n= number of years, lets assume n = 1 for simplicity of calculation; r = discount rate or the IRR to set NPV to 0. In this calculation, we will use uniform values for both NPV and IRR and let us see the result:


185,000 = 100,000/(1+r)^1

185,000 = 100,000/(1+r)

1+r = 100,000/185,000
r= (100,000/185,000) – 1
r= 0.54-1
r= -0.45 >>> this means to have an NPV of 185,000 for 1 year with Individual amount of 100,000 a year, discount rate is even least imagine negative (-0.45)?

Now let us check, what about the iRR of 18%?

0.18 + 1= 100,000/x; let X= NPV
X = 100,000/1.18
X = 84,745 this means, at a discount rate of 18%, NPV will be 84,745

Now given the two scenarios, which one you will select? For sure you will select that one with higher NPV, and that is 185,000, as the rate of 18% will only give NPV = 84,745.

Note that 0.18 is used as a "discount rate" and in fact not yet the IRR to set NPV to 0. The discount rate that could set NPV to zero is the IRR. in my example calculation, the more you increase the discount rate, the more it will give u small NPV (this is because we only use 1 year instead of progressive years this caused the scenario tricky). To get NPV as 0, there could be 2 values of IRR, one IRR= 0 will give us NPV = 0, and the other value is even more than 100% ot inifinity. See that? This is the reason why IRR can fool us according to expert.

So for me, there is no doubt that the within the limits of the given in the Question, my best choice is that project with NPV=185,000.

For additional information and excerise to prove how the NPV and IRR are used,, try to visit this link

http://hspm.sph.sc.edu/courses/econ/invest/invest.html

 

 

 

saket_pmp

Tue, 05/15/2012 - 06:27

A BIG THANK YOU to you.


Although, this is more on economics now, but excellently you have explained.


I went to IRR just because of its simplicity as it shows you a direct result. The IRR method simplifies projects to a single number that management can use to determine whether or not a project is economically viable. The result is simple, but for any project that is long-term, that has multiple cash flows at different discount rates, or that has uncertain cash flows - in fact, for almost any project at all - simple IRR isn't good for much more than presentation value. (I should have thought this too)


I agree with you, in this scenario (with what's being given), NPV should be the best option.

philzs

Mon, 10/06/2014 - 13:39

Anyone can explain the pmp difference between irr and discount rate

I did a question on PMStudy where it ask
"The rate used in your compagny to calculate the present value of expected yearly benefits and costs is refered to as:

1 interest rate
2 discount rate
3 internal rate of return
4 Benerif cost ratio

Answer: 2

I am asking me what is the difference between 2 and 3

thanks