CFAI Reading 44 Capital Budgeting, Q 11

the question states: An investment has an outlay of 100 and after-tax cash flows of 40 per annum for 4 years. a project enhancement increases the outlay by 15 and the after-tax cash flows by 5 per annum. As a result the vertical intercept of the NPV profile of the enhanced project shifts: A. up and the horizontal intercept shifts left B. up and the horizontal intercept shifts right C. down and the horizontal intercept shifts left D. down and the horizontal intercept shifts right I’m not sure even how to approach this - the text says very little about NPV profiles as far as I can tell. Surely you don;t have to calculate the original NPV for a range of discount rates, plot them on a graph and then recalculate the new NPV for the same range of discount rates? Thanks

First : NPV profile’s horizontal intercept is determined by IRR. Higher IRR will shift horizontal intercept to the right. Second : Vertical intercept refers to NPV calculated with zero discount rate. If discount rate is zero… -15 ouflow and +20 (i.e. $5 X 4 years) inflow will result in net +5 inflow… thus increasing NPV and shifting vertical intercept up.

righto, thanks very much.

kamran, I disagree. If you calculate IRR for both situations, you will see that IRR is less than the original which will move the horizontal intercept to the left.

newsuper Wrote: ------------------------------------------------------- > the question states: > > An investment has an outlay of 100 and after-tax > cash flows of 40 per annum for 4 years. a project > enhancement increases the outlay by 15 and the > after-tax cash flows by 5 per annum. As a result > the vertical intercept of the NPV profile of the > enhanced project shifts: > > A. up and the horizontal intercept shifts left > B. up and the horizontal intercept shifts right > C. down and the horizontal intercept shifts left > D. down and the horizontal intercept shifts right > > I’m not sure even how to approach this - the text > says very little about NPV profiles as far as I > can tell. Surely you don;t have to calculate the > original NPV for a range of discount rates, plot > them on a graph and then recalculate the new NPV > for the same range of discount rates? > > Thanks You don;t need a calculator to see that the IRR goes down with the enhancement - the original cash flows (an annuity, btw) were 40/100 = 0.40 on an annual basis. The enhancement cash flows (taken as a separate priject) return 5/15 or 33%. So, mixing the twi projects will result in an IRR that is lower than the original one. This moves the horizontal axis intercept to the left. As stated previously, the NPV increases by $5. So, it’s “A”

You are right busprof. I overlooked calculation of IRR