Consider two mutually exclusive projects. The crossover rate for the two project
ID: 2714929 • 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
Crossover Rate is the rate at which both the projects have the same NPV. The crossover rate is 12%
A) SInce project 1 has a higher NPV at 10% (lower than the crossover rate), project 2 will have have a higher NPV at 15%(higher than the crossover rate). Thus, project 2 is better than project 1 at 15%.
Let us consider the following cash flows:Both have an NPV of 5000 at 12%.
At 10%, the cash flows are as follows:
Project 1 has a higher NPV tham Project 2
Now, at 15%, the cash flows are as follows:
Project 2 has a higher NPV than project 1.
B)
It can be seen from the above graph that below the crossover point (a dicount rate of 12%), project 1 has a higher NPV while above the crossover point, project 2 has a higher NPV. At the crossover point, both the projects have the same NPV.
Year Project 1 Cash Flow Project 1 Discounted Cash Flow Project 2 cash flow Project 2 discounted cash flow 0 -3000 -3000 -2000 -2000 1 8960 8000 7840 7000 Project 1 NPV 5000 Project 2 NPV 5000