Thursday, August 9, 2007

PV Formula for PMP Exam

Present Value:
Just thought of writing my understanding as a blog. Would be delighted if someone found this useful.

Present Value or PV is the value of the investment in today's terms. It is the value of future cash flows of the project in today's dollars.

This is a discounted cash flow technique and one of the Benefit Measurement Methods under the Project Selection Methods tool and technique which is used for creating a Project Charter.

Ouch, that was quite long. To repeat, the Project Charter creation process uses a tool and technique called Project Selection Methods. One of the techniques under the Project Selection Method is Discounted Cash Flow which calculates Present Value.

The formula for calculating a Present Value is
PV = FV/(1 + i)n
where
PV - Present Value to be calculated
FV - Expected Future Cash inflow
i - Notional Interest or Expected Rate of Interest

Net Present Value:
This is another interesting twist to calculate the Net future income/future cash inflow of the project in today's dollars. There is no big difference or additional concept to remember here. This is just a sum of all the expected Present values subtracted by the investment. For example, if we assume that the following are the given values.

Invested Amount : $5,00,000
Income Expected (Future Value)- 1 Year : $200000
Income Expected (Future Value)- 2 Year : $300000
Income Expected (Future Value)- 3 Year : $100000

Rate of Interest : 5% per annum

Now calculate the Present value for every year with the Present Value (PV) formula.


Year
Future Value
Calculation
PV
1 $2000002,00,000/(1 + .05)190476.2



2 $3000003,00,000/(1 + .05)2 272108.84



3 $1000003,00,000/(1 + .05)3 86383.76










Total NPV (For 3 years) = 5,48,968.8

NPV for the project = Total NPV (For 3 years) - Original Investment = 5,48,968.8 - $5,00,000



So the final NPV is 48,968.8.

And the formula for calculating the Net Present Value is,
NPV = PV1 + PV2+ PV3 .. + PVn - Invested Amount

According to the theory of NPV if the calculation of NPV yields a positive value or more than zero, then it is expected to make profit. It can get a go recommendation if all other factors look good. Additional points to remember are like,
  • NPV assumes that the cash flows are re-invested at the cost of capital. ie, the same interest rate
  • If NPV calculation is greater than zero accept the project. Otherwise reject the project
  • Another note is that projects with high returns early in the project are preferred over the ones with lower returns early in the project.

20 comments:

Inderpal Rana said...

Thank you so much, it was really very helpful and very well defined

Kathy said...

Yes, this was exactly the type of example I wanted to see to help me understand. Thanks!

Kathy said...

Agreed. Very good example that helped a lot!

xevi said...

Gracias!

Nitya Sriram said...

Thanks a lot, very easy to comprehend... I indeed found it very useful...

Chee Khang Ang said...

Thank for for the post.
I had confusion in PV, FV and NPV but your explanation cleared my doubt.

Chee Khang Ang said...

Thank you for the note.
I had been confused in PV, FV and NPV. your good explanation cleared my doubt.

Doolin said...

Very helpful for my PMP exam preparation, thank you.

Doolin said...

Thank you, this was very helpful for my PMP exam preparation.

KiranRoy said...

Concept is very useful to understand. Thank you so much.

Therese H said...

Great example, but found the solution a bit confusing--"5,48,968.8 - $5,00,000"? Are there 0's missing, or are the commas in the wrong place?

osahon ohenhen said...

So helpful. Thanks

Unknown said...

Very nice explanation. Thanks

Unknown said...

Very nice explanation. Thanks

Amit said...

It is very helpful as defined so well in simple language and with simple examples . Thanks a lot

Tabitha Lashley said...

Very helpful thank you!

Sourajit Majumdar said...

Thanks a lot...its really easy to understand...

motunrayo babafemi said...

Thank you! Came in handy!

Megan Vaudry said...

WOW! I have been stuck on a NPV Practice question forever and using the breakdown you suggest, I finally got it!

Thank you!

Gareth Thomas said...

struggled with this for last few days but this explains it! Thanks