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Return on Investment

5 minutes 5 Questions

Return on Investment (ROI) is a financial performance measurement used to evaluate the efficiency of an investment or compare the efficiency of multiple investments. In project management, ROI helps in determining the potential benefits a project is expected to bring when compared to the cost associated with executing the project. It is calculated by dividing the net benefits or net profit by the initial cost of investment, and the result is expressed as a percentage. A positive ROI indicates that the project is profitable and contributes positively to an organization's bottom line, while a negative ROI indicates a loss-generating project.

Guide: Understanding and Answering Questions on Return on Investment (ROI) as per PMBOK Guide Seventh Edition

Importance: Return on Investment (ROI) is an integral part of cost management as it aids in assessing the efficiency of an investment or comparing efficiencies of different investments. From a project management perspective, it’s crucial because it offers a quantitative measure of the anticipated benefits against the project costs.

Definition: ROI is a ratio derived by dividing the net profit by the total investment. It is usually expressed as a percentage and is often used to make business decisions.

Working: To calculate ROI, the profit of an investment is divided by the cost of the investment and the result is expressed as a percentage or a ratio. Hence, ROI = (Net Profit / Cost of Investment) * 100.

Answering Questions: Read the exam questions carefully to understand the values given and what is asked. Make sure you’re familiar with the formula and calculations – especially on calculating net profits.

Exam Tips:
- The bigger the ROI, the better the investment
- Practice the ROI formula; accuracy in calculations is the key to getting these types of questions right on the exam
- ROI isn't always the best indication of project value, other factors like strategic fit, risk levels, and absolute cost should also be considered.
- Note that unlike other techniques, ROI takes both revenues and costs into account

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PMP - Cost Management Example Questions

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Question 1

Your project requires an initial investment of $200,000, and can generate an annual cash inflow of $40,000. The project lasts for 8 years. If you manage to increase the cash inflow by 25%, how will the ROI change?

Correct Answer: It will increase by 40 percentage points.

To solve this problem, let's first calculate the Return on Investment (ROI) with the given information, and then recalculate it with the 25% increase in cash inflow. Given: - Initial investment: $200,000 - Annual cash inflow: $40,000 - Project duration: 8 years Step 1: Calculate the total cash inflow over the project's life. Total cash inflow = Annual cash inflow × Project duration Total cash inflow = $40,000 × 8 = $320,000 Step 2: Calculate the ROI. ROI = (Total cash inflow - Initial investment) / Initial investment × 100% ROI = ($320,000 - $200,000) / $200,000 × 100% = 60% Now, let's calculate the ROI with a 25% increase in cash inflow. Step 3: Calculate the new annual cash inflow. New annual cash inflow = Annual cash inflow × (1 + Increase percentage) New annual cash inflow = $40,000 × (1 + 0.25) = $50,000 Step 4: Calculate the new total cash inflow over the project's life. New total cash inflow = New annual cash inflow × Project duration New total cash inflow = $50,000 × 8 = $400,000 Step 5: Calculate the new ROI. New ROI = (New total cash inflow - Initial investment) / Initial investment × 100% New ROI = ($400,000 - $200,000) / $200,000 × 100% = 100% Therefore, with a 25% increase in cash inflow, the ROI will increase from 60% to 100%, a change of 40 percentage points.

Question 2

You are assigned to a project with an initial investment of $600,000. The project brings an annual cash inflow of $120,000. If your financial advisor suggests to reach an ROI of 25%, what should be your approach?

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

To reach a Return on Investment (ROI) of 25%, the project either needs to increase its annual cash inflow, reducing the time frame necessary to achieve the ROI, or decrease the initial investment, thus lessening the amount needed for the 25% return. Option 'Increase the initial investment' is incorrect because increasing the initial investment would require an even larger cash inflow to reach the desired ROI. Option 'Shorten the project duration' doesn't necessarily correlate to a higher ROI, for it doesn't control the cash inflow or the initial investment. Same applies to 'Increase the project duration' which could even decrease the ROI as it could increase the total costs.

Question 3

Project A has an initial investment of $900,000 with an expected annual cash inflow of $150,000. The project duration is expected to be 5 years. What is the ROI if the annual cash inflow is increased by 10%?

Correct Answer: -8.33%

To calculate the Return on Investment (ROI) with a 10% increase in annual cash inflow, let's first identify the given information: - Initial investment: $900,000 - Expected annual cash inflow: $150,000 - Project duration: 5 years - Increase in annual cash inflow: 10% Now, let's solve the problem step by step. Step 1: Calculate the total cash inflow with a 10% increase. Increased annual cash inflow = $150,000 × 1.10 = $165,000 Total cash inflow = Increased annual cash inflow × Project duration Total cash inflow = $165,000 × 5 = $825,000 Step 2: Calculate the net profit. Net profit = Total cash inflow - Initial investment Net profit = $825,000 - $900,000 = -$75,000 Step 3: Calculate the ROI. ROI = (Net profit / Initial investment) × 100% ROI = (-$75,000 / $900,000) × 100% = -8.33% Therefore, if the annual cash inflow is increased by 10%, the ROI for Project A would be -8.33%. This negative ROI indicates that the project would still result in a loss, even with the increased cash inflow.

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