Two investment projects being considered by a company. Project 1 is expected to receive larger cash flows early in the life of the project, Project 2 is expected to receive larger cash flows late in the life of the project. Except for that they are both identical. Which project has the steeper NPV profile? I can’t see what I’m doing wrong here. I get project 1 will have the steeper line because since the project has high cash flows earlier it’ll have a higher npv and lower irr. The second one will have a lower NPV and higher IRR. Therefore the second one is flatter than the first. Am i missing something here cos the answer is the second.! This is driving me crazy
I think project 1 also makes sense for the reasons you sited. Higher cash flows early on, getting discounted by smaller factors, will make for a steeper curve.
It’s good to see it’s not just me: This is what the answer says: All else equal, a delay in the receipt of cash flows will make a project’s net present value more sensitive to changes in the discount rate; the increased sensitivity is illustrated by a steeper slope in the net present value profile. I’m trying to understand it graphically and it’s not making sense
Input numbers on your calculator using the CF function. Then compare these while referring to a graph. Y axis is NPV, X- axis is the rate. Maybe that’ll help
As the discount rate increases, the NPV of project 2 will experience higher discounting as you move along the curve. discount = (1 + r) ^ t ‘t’ is the explanation for this answer, as it gets bigger, the cash flow gets smaller.
Early cash flows --> flatter NPV profile --> Higher IRR Late cash flowa —> steeper NPV profile–> lower IRR Mathematically, higher cash flows later will require lower IRR because of number of years will increase the factor in the denominator (factor being (1+IRR)^N)
I just did a example using 5% and 20% and the second option had the larger jump in value. A NPV profile shows the NPV at different discount rates. So changing the rate you can see how the slope of the profile will be changed and option #2 is the larger shift in value
I think I am getting confused because i thought that the projects crossed at some point. So in this case there is no discount rate where the NPV’s are equal. Is this correct?
No, they will intersect where NPVs are equal.
project 2 will have the steeper NPV profile. With the cash flows being gretaer at the end of the projects life, any shift in the discount factor will cause the PV to shift more than a project where cash flows are larger at t he beginning. Just think about exponential component in the DCF itself and this makes perfect sense.
I got it now thanks… Re-read the whole chapter. Makes sense now. Thanks for your help
also this ties well into time value of money, the futher in time you go, the lower your present value.
This is a terrible question to ask in a short time, unless one has seen it before!
thunderanalyst Wrote: ------------------------------------------------------- > Early cash flows --> flatter NPV profile --> > Higher IRR > > Late cash flowa —> steeper NPV profile–> lower > IRR > > Mathematically, higher cash flows later will > require lower IRR because of number of years will > increase the factor in the denominator (factor > being (1+IRR)^N) awesome…might as well committ this to memory…too late to learn anything now!