Example: Consider two projects
Example:
Consider two projects. The first project pays benefits of $90today and nothing else. The second project pays nothing today,nothing one year from now, but $100 two years from now. Whichproject would be preferred if the discount rate were 2%? What ifthe rate increased to 10%?
– For a discount rate of 2%, the present value calculationswould be $90 for project one and $96.12 for project two; therefore,project two is preferred. At a rate of 10%, the PV of project oneis still $90. For project two, the PV is now 100/1.1^2= 82.6;therefore, project one is preferred.
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Consider two projects. The first project pays benefits of $90today and nothing else. The second project pays nothing today,nothing one year from now, but $100 two years from now. Whichproject would be preferred if the discount rate were 2%? What ifthe rate increased to 8%?
Answer:
CASE 1
Discount rate = 2% or 0.02
The first project pays benefit of$90 today.
The present value of benefitreceived today is amount itself.
Thus,
The present value ofbenefits from first project is $90.
The second project pays $100 twoyears from now.
Calculate the present value –
PV = $100/(1+0.02)2 =$100/(1.02)2 = $100/1.0404 = $96.12
The present value ofbebefits from Project 2 is $96.12
The present value ofbenefits from Project 2 is higher.
So, at discount rate of 2%,Project 2 would be preferred.
CASE 2
Discount rate = 8% or 0.08
The first project pays benefit of$90 today.
The present value of benefitreceived today is amount itself.
Thus,
The present value ofbenefits from first project is $90.
The second project pays $100 twoyears from now.
Calculate the present value –
PV = $100/(1+0.08)2 =$100/(1.08)2 = $100/1.1664 = $85.73
The present value ofbebefits from Project 2 is $85.73
The present value ofbenefits from Project 1 is higher.
So, at discount rate of 8%,Project 1 would be preferred.
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