Net Present Value Formula PMP®
When selecting a project to pursue, it’s crucial to consider how inflation and deflation will impact your project’s future value. For example, there is a difference in the purchasing power of $1,000 today and the same amount five years in the future. The concept of Net Present Value helps PMP® credential holders account for this difference in the project selection process. You will most likely not have to use the Net Present Value formula on the PMP Exam. However, this concept is still essential to successfully answering questions about project selection. Learn more and practice your understanding using this Project Management Academy resource.
PMP® Exam Formula Cheat Sheet
Learn how to successfully use project management formulas after reading this cheat sheet.
Definition of Net Present Value Formula PMP
Present Value (PV) describes the future value of a project in terms of today’s money adjusted or “discounted” for inflation. Net Present Value (NPV) takes this concept a step further and describes the difference between the project’s cash value now and in the future. In other words, NPV helps PMP exam candidates conceptualize the time value of money.
You may use the PMP exam-related concept of NPV to analyze cash flow, assess project profitability, or calculate benefit-cost ratios. The result of using a net present value formula will tell you whether or not a project will be profitable in the future.
Generally, you can interpret net present values this way:
- Positive NPV (NPV > 0): the project is profitable. The anticipated financial gains outweigh your present-day investment.
- Negative NPV (NPV < 0): the project is not profitable. Expenses are more significant than returns, so you will likely lose money on this project.
- A net present value of 0 is unrealistic. It essentially means there will be no return on your investment, but you won’t lose money either.
You can use NPV as a profitability indicator. A larger NPV indicates a more profitable project. Considering a project’s NPV can help you to decide whether you should pursue a project or to compare various project options and select the best one.
Studying for the PMP Exam?
NPV Calculation PMP
As we mentioned, the PMP Exam is unlikely to ask you to perform the actual calculation of a net present value. However, recognizing the different elements of the net present value formula will help you better understand this necessary concept.
NPV Calculation PMP Assumptions
There are a few assumptions that can be made from the NPV formula:
- Cash flows: this term describes the net revenue of a project. Cash flows usually stem from a business projection, and an estimation is generally sufficient for calculating NPVs.
- Discount and interest rates: while in reality, discount and interest rates may vary during different periods and for various cash flows, a basic net present value calculation generally uses a constant rate.
- Residual value: when projecting long-term cash flows, there is a point at which your estimates will lose accuracy or become too complex. In these cases, residual value describes the remaining value of your project or deliverables.
Since NPV is a foundational business math concept, it is necessary to know and understand the net present value formula. However, knowing other metrics beyond this is not necessary for the PMP Exam.
Net present value formula PMP
You may see a few variations of the net present value formula, but it essentially boils down to the following calculation:
In this formula:
- Cash Flow represents the positive or negative revenue of the project in year “n”
- “r” represents the interest or discount rate
- “n” represents the year
- Initial Cost represents the financial investment in a project
In other words, the net present value equals the sum of each year’s cash flow adjusted for inflation.
You may find some NPV formulas also account for your project’s initial cost or residual value. In these cases, you would subtract the initial cost or add the residual value for the final calculation of net present value.
NPV PMP Example
Let’s say you are comparing two projects to decide which one to pursue. Project A has an NPV of $10,000 and takes three years to complete. Project B has an NPV of $20,000 and takes five years to complete. Which project will you choose?
Since NPV already considers the time value of money, you don’t need to account for how long a project takes to complete. Therefore, you only need to compare the net present values of each project. Project B has a higher NPV, so that is the project you should choose.
NPV PMP Exam tips
If you conceptually understand NPV, you are in great shape for the PMP exam. The actual calculation using the net present value formula is more than likely not something you need to know how to do to take the exam.
Remember NPV already considers the time value of money, so if a question asks you to compare projects with different NPVs and lengths of time, you only need to compare the NPV of each project. You should also be able to apply and interpret the term and NPV formula to answer various questions.
However, the likelihood you will get more than a handful of questions referencing the concept of an NPV is generally small. Use the questions below to practice applying and interpreting NPVs for the PMP exam, and make sure to reach out to your experts at Project Management Academy if you have any further questions.
NPV PMP sample questions
Practice your understanding of the net present value formula for the PMP exam. Check your answers to these questions at the bottom of the page.
|You have four possible projects but can only choose one. Project A is being done over a six-year period and has a net present value (NPV) of $70,000. Project B is being done over a three-year period and has an NPV of $30,000. Project C is being done over a ten-year period and has an NPV of $40,000. Project D is being done over a one-year period and has an NPV of negative $160,000. Which project should you choose?
|You have four possible projects but can only choose one. Project A is being done over a six-year period and has a net present value (NPV) of $70,000. Project B is being done over a three-year period and has an NPV of $30,000. Project C is being done over a ten-year period and has an NPV of $40,000. Project D is being done over a one-year period and has an NPV of negative $160,000. To know which project to choose, you want to make sure you understand all involved selection methods. What is definition of present value?
|Value of assets a company owns
|Today’s value of future cash flows
|Future value of money on hand today
|Current value of today’s assets adjusted for inflation
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- A. You should always pick the project with the highest Net Present Value (NPV), which in this case is Project A. Since the NPV formula already takes into consideration the time value of money, you can completely ignore the number of years. Also remember if NPV is negative, like Project D, you always reject it.
- B. Present Value is today’s value of future cash flows. Generally calculated using formula PV = FV / [1+i] ^n, where FV = Future value, i = rate of interest, and n = number of years (^ signifies an exponent). Net Present Value is the cumulative sum of PV. This is an example of when PMI might use a similar question setup, but change the call of the question. You must be sure you are readying the entire question to ensure you understand what is being asked of you.
NPV PMP summary
The concept of Net Present Value is a relatively simple-to-understand concept. This makes it useful for PMP credential holders who need to perform cost-benefit analyses, select the best project from multiple options, or determine whether or not a project is worth pursuing.
Understanding how to apply and interpret NPV will help prepare you for success on the PMP exam. Do you have more questions about NPV or PMP Exam Prep Training? Look into our live classroom prep courses or online certification training for more information.