Consider two mutually exclusive projects. The crossover rate for the two project
ID: 2714626 • Letter: C
Question
Consider two mutually exclusive projects. The crossover rate for the two projects is 12%, at which point both have an NPV of $5,000. At a discount rate of 10%, Project 1 has a higher NPV than Project 2.
a. If the appropriate discount rate is actually 15% (not 10%), which project is better? Explain your answer.
b. Draw a rough sketch of NPVs and the crossover point to illustrate your answer. Use the following additional information as needed: Project 1’s IRR is 15%. Project 2’s IRR is 22%. Label the information provided on your graph.
Explanation / Answer
The two mutually exclusive projects having the crossover rate of 12% where the NPV of both projects is $ 5000. As already told that at the lower discount rate i.e. 10%, the Project 1 has the higher NPV than the Project 2, so we will consider the Project 1 for execution.
Now, when we consider the appropriate discount rate as 15% instead of 10%, the Project 2 will be prefered because at the higher discount rate the NPV of the Project 2 will high as the rate of return i.e. IRR will be higher. At 15% the return of the Project 1 will be negative as it is providing higher NPV/return in the shorter life span.
When we have only IRR to consider the acceptance of the Project, the project have the higher IRR will be preferred over the other projects because over the longer period the higher IRR project will give great return. So, Project 1's IRR is 15% will be less preferred to the Project 2's IRR is 22%.