18. Capital Budgeting Decision Criteria: NPV Profile Capital Budgeting Decision

Question

18. Capital Budgeting Decision Criteria: NPV Profile Capital Budgeting Decision Criteria: NPV Profile NPV Profile A project's NPV profile graph intersects he Y axis at 0% cost o capital and intersects t ex a as at the project's s where NPV O hey.axis intersection pointrepresents he pro acts undiscounted M The point at which 2 projects' profiles cross one another is the crossover.rate. The crossover rate can be found by calculating the -Select-.of the differences in the projects' cash flows (Project Delta). A -elect NPV profile indicates that increases in the cost of capital lead to large declines in NPV. If a project has most of its cash flows coming in later years, its NPV will Select sharply if the cost of capital increases; but a project whose cash flows come earlier will not be severely penalized by high capital costs. The significance of the crossover rate is that at any cost of capital -elect than the crossover rate, the NPV and IRR methods will provide the same conclusion for evaluating mutually exdusive projects. However, at any cost of capital -Select than the crossover rate, the NPV and IRR methods conclusions will conflict. In that situation, the -Select method will always provide the correct project acceptance result. Quantitative Problem: Bellinger Industries is considering two projects for inclusion in its capital budget, and you have been asked to do the analysis. Both projects' after-tax cash flows are shown on the time line below. Depreciation, salvage values, net operating working capital requirements, and tax effects are all included in these cash flows. Both projects have 4-year lives, and they have risk characteristics similar to the firm's average project. Bellinger's WACC is 12%. Project A 1,050 Project 81050 320305 400 659 705 360 200 310 What is Project Delta's IRR? Round your answer to two decimal places.

Explanation / Answer

Answer:

1. IRR as at this point NPV = 0.

2. Crossover Rate is calculated by finding difference between Initial Investment and period cash flow of two projects.

3. A steep NPV profile indicate that with increase in cost of capital the NPV declines sharply.

4. If most of the cash flows coming in the later years, NPV will fall sharply with increase in cost of capital.

5. When Cost of Capital is more than crossover rate then mutually exclusive will give same results.

6. When Cost of Capital is less than crossover rate then conflicting results are received.

7. In that case, NPV is always correct acceptance method.

Second Analysis:

1. IRR:    Project A: 23.26%

   Project B: 18.92%

2. After IRR > WACC , there is no conflict in selection of mutually exclusive projects. NPV is used to select the project and project with higher NPV is selected.

3. Profile D: NPV profile of two projects.

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