I am not gettting the exact use of NPV profile. Could somebody please explain? I believe it is not for project selection because we can select projects just by using NPV alone. The question of which project is better can be decided from NPV which intun is dependant on the cost of capital. When I have two projects and the cost of capital for those projects, I knew which project is going to add more value to me from NPV. Now why would somebody go and create a chart asuming different cost of capital for these projects and derive the crossover rate? What is the real use of NPV profile in investment decision making??
Any thoughts on this please?
If a company is not sure what interest rate to use, NPV profile gives valuable information. For example, If the cash flows occur near the end of the project, NPV profile will be steeper (it will fall sharply as you increase the rate). So if 2 projects are giving same NPV at some rate, and company wants to select one of them, NPV profile will help in that.
NPV profile helps assess project risk. If NPV is very sensitive to discount rate -> its risk is higher compared to projects with less sensitivity.
Here is a question on NPV profile: Microbrew, Inc. is considering projects X and Y, which have internal rates of return (IRRs) of 14% and 17%, respectively. The net present value (NPV) profile shows a crossover rate of 9%. If the cost of capital for each project is 8%, Microbrew can only fund one of the projects, and the two projects are mutually exclusive, Microbrew should: a. Accept project X because it has larger NPV. b. Accept project Y because it has a larger NPV. c. Accept project Y because it has a larger IRR. d. Reject both projects.
A. per the NPV profile, if the cost of capital is less than the crossover rate, then the project with lower IRR will have a higher NPV value and vice versa. Thanks for bringing this question
That’s correct, A is the answer.