On Friday I received a question. Should a project be accepted or not? A simple question and should be peanuts for some people. Here are the information related to the project.
1. Investment: RM 1,000,000
2. Revenues: Year 1 – RM 250,000, Year 2 – RM 420,000 and Year 3 – RM 420,000.
3. Total Revenue is RM 1,090,000. Net Revenue is RM 90,000.
4. Discount rate = 10%
What do you think? Simple, right?
The thing is I did not study Accounting and I hardly paid attention during my Engineering Economics 101 in school. This should have been a breeze if otherwise..
It took me about an hour to figure this out. I am rusty all over when it comes to something such as this. Firstly, how do you determine whether this project is attractive or not? I hope you would not say based on the Net Revenue because that will be wrong. From school, the answer would be to find out the Net Present Value (NPV) of the project over the 3 years cycle. So, the next thing to do is look for the formula!
Present Value (PV) = FV / (1 + i)t where FV – the Future Value, t – the time of the cash flow and i – the annual interest rate
Based on that we need to calculate the Future Value (FV). So, NPV would be the Sum of FV minus the Initial Investment. Since the information provided the discount rate and not interest rate, therefore,
Discount Factor = 1 / (1 + i)t. Discount factor refers to the rate used to discount future cash flows to the present value. So, we then have, FV = PV (1 / (1 + i)t). With all the above information in place, just use MS Excel and run the calculations:
Based on the calculation above, the sum of the Future Value is only RM 889,932.38. As such, the Net Present Value will be -RM 110,067.62, a negative figure. The negative NPV makes this project unattractive. We should not accept this project.
So, if you do not understand this, don’t worry. Just don’t do the kind of job that I do.. Peace!