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Return on Investment (ROI)

5 minutes 5 Questions

ROI is a performance measure to evaluate the efficiency of an investment. In the project management context, it's used to understand the amount of return on a project relative to the project’s total cost. It can be calculated as (Net Profit/Total Project Cost) * 100. This concept is crucial for project selection, as projects with higher ROI are more likely to be chosen.

Guide on Return on Investment (ROI)

Return on Investment (ROI) is a critical metric in project cost management under the broader concept of the capital asset pricing model (CAPM).

Why is it important?
ROI is crucial because it quantifies the profitability of an investment or project. It expresses the net benefit (profit or loss) as a percentage of the total investment to reasonably compare different investments. Further, it assists investors in making informed decisions.

What is Return on Investment?
It is the ratio between the net gain from an investment and the cost of the investment. The formula to calculate ROI is (Net Profit / Cost of Investment) x 100%.

How does it work?
A positive ROI implies a profitable investment, while a negative one suggests a loss. A higher ROI percentage indicates higher profitability.

Exam Tips: Answering Questions on ROI
In an exam situation, understanding the concept and formula is essential. Here are few tips:

  • Be clear about what constitutes the 'Net Profit' and 'Investment Cost'.
  • Understand the implications of a positive, negative, and zero ROI.
  • When asked for comparative analysis, the investment with higher ROI is usually the more profitable one.
  • Where possible, provide detailed workings and explanations to support your computation, and use real-life examples to support your arguments.

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CAPM - Project Cost Management Example Questions

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Question 1

You are overseeing a project with an initial investment of $500,000 and it generates an annual cash inflow of $70,000. Considering a project lifespan of 10 years, if you can save 15% on the initial investment without affecting the cash inflow, what will be the new ROI?

Correct Answer: 65%

To calculate the new ROI (Return on Investment) with a 15% reduction in the initial investment, we need to follow these steps: 1. Calculate the new initial investment: Original investment = $500,000 Reduction = 15% of $500,000 = 0.15 * $500,000 = $75,000 New initial investment = $500,000 - $75,000 = $425,000 2. Calculate the total cash inflow over the project lifespan: Annual cash inflow = $70,000 Project lifespan = 10 years Total cash inflow = $70,000 * 10 = $700,000 3. Calculate the total profit: Total profit = Total cash inflow - New initial investment = $700,000 - $425,000 = $275,000 4. Calculate the new ROI: New ROI = (Total profit / New initial investment) * 100% = ($275,000 / $425,000) * 100% = 0.6471 * 100% = 64.71% ≈ 65% (rounded to the nearest whole percent) Therefore, if you can save 15% on the initial investment without affecting the cash inflow, the new ROI will be approximately 65%.

Question 2

Your project has an initial cost of $500,000 and is set to generate a cash inflow of $100,000 annually. If your company's ROI expectation is 40%, how should you adjust the project?

Correct Answer: Increase the annual cash inflow or decrease the initial cost.

The correct answer is to 'Increase the annual cash inflow or decrease the initial cost.' The goal is to get a 40% Return on Investment (ROI), so we must make adjustments to increase profit or decrease expenses. 'Decrease the annual cash inflow' is incorrect because it would decrease the ROI, not increase it, thus moving further from the goal. Similarly, 'Increase the initial cost' is wrong because that would also lower the ROI, not increasing it. Lastly, 'Extend the project duration' could possibly increase total returns, but it may not necessarily increase the profit per year, which is what ROI measures.

Question 3

A project with an initial investment of $400,000 attracts annual cash inflows of $80,000. If the company's ROI expectation is 35%, what measures can you take to achieve this target?

Correct Answer: Increase the annual cash inflow or reduce the initial cost.

The question concerns the achievement of a specific Return on Investment (ROI) target in a project management context. The ROI is a measure of the efficiency of an investment and is calculated by comparing the profit or loss made on an investment with the amount invested initially. To increase the ROI, you can either increase the returns (profits) or decrease the initial outlay (investment). With an initial investment of $400,000 and an annual cash inflow (returns) of $80,000, the company wishes to achieve an ROI of 35%. To meet this expectation, the company could increase the annual cash inflow, thus boosting profits, or decrease the initial investment. The answer 'Decrease the project duration' is not necessarily correct because decreasing the time frame does not directly affect the ROI unless it leads to a proportionate increase in annual cash flows. 'Increase the initial cost' and 'Decrease the annual cash inflow' are both counterproductive as they would actually lower the ROI rather than increase it.

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