Crossover rate Crossover rate is the discount rate that makes the NPVs of two

Crossover rate crossover rate is the discount rate

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Crossover rate Crossover rate is the discount rate that makes the NPVs of two projects equal How to find the crossover rate? Compute the (B-A or A-B) cash flows and find IRR of (B-A or A-B) 50
Find IRR of (B-A) 51 Yea r Project A Project B B-A 0 -$100 -$100 $0 1 50 20 -$30 2 40 40 $0 3 40 50 $10 4 30 60 $30 IRR 24% 21% 11.1% Crossover rate
Question - Crossover rate You are comparing two mutually exclusive projects. The crossover point is 12.3 percent. You have determined that you should accept project A if the required return is 13.1 percent. This implies you should: A. always accept project A. B. be indifferent to the projects at any discount rate above 13.1 percent. C. always accept project A if the required return exceeds the crossover rate. D. accept project B only when the required return is equal to the crossover rate. E. accept project B if the required return is less than 13.1 percent. 52
IRR: advantages & disadvantages Advantages Disadvantages Closely related to NPV, often leading to identical decisions May result in multiple answers Easy to understand and communicate May lead to incorrect decisions in comparisons of mutually exclusive investments 53
NPV, IRR, PI problem A firm is considering a project that costs $1,200 and generates cash flows of $500 in the first year, $600 in the second year and $700 in the third year. Compute the NPV, IRR and PI of this project. The appropriate discount rate is 10 percent. 54
Yr 0 Yr1 Yr2 Yr3 -1200 500 600 700 Conventional cash flows Not a case of mutually exclusive events (no other event you need to consider) NPV, PI, and IRR give the same answer 55
1) NPV=(500/1.1+600/1.1 2 +700/1.1 3 )-1200= 276.33 (>0) => Accept the project Or using a financial calculator CF0=-1200; C01=500; F01=1; C02=600; F02=1; C02=700; C03=1; NPV (I=10); CPT NPV= 276.33 2) IRR Using a financial calculator CF0= -1200; C01=500; F01=1; C02=600; F02=1; C02=700; C03=1; IRR CPT IRR=21.92% (at IRR, NPV=0) Accept the project since IRR(=21.92%) > required return(=10%) 3) PI PI = PV of cash inflows/PV of cash outflows = (500/1.1+600/1.1 2 +700/1.1 3 )/1200 = 1476.33/1200= 1.23 Accept the project since PI is greater than 1. 56
Payback period Amount of time required to generate cash flows sufficient to recover initial cost Payback Rule: Accept a project if its payback period is less than some prespecified number of years (“cutoff point”) 57
Payback problem Compute payback period for the following projects Year A B C 0 -$9,000 -$11,000 -$200 1 2,000 2,000 100 2 3,000 3,000 100 3 4,000 4,000 -200 4 5,000 5,000 200 5 6,000 6,000 C=2 yrs or 4 yrs? Both are correct ; ambiguous answers in this case 58 B=3yr+2000/5000=3.4 yrs =3yrs (since -9000+2000+3000+4000=0)
Payback does not consider cash flows after cutoff date Your firm has two projects: Long and Short. The discount rate is 15% and the cutoff point is 2 years. Year Long Short 0 -$250 -$250 1 100 100 2 100 200 3 100 0 4 100 0 Payback period (yrs) 2.5 1.75 NPV $35.50 -$11.81 59 Payback period rule: Choose Short NPV rule: Choose Long
Payback: advantages & disadvantages Advantages Disadvantages Easy to understand Ignores time value of money Adjusts for extra riskiness of later cash flows Requires an arbitrary cutoff point Favors investments that free up cash quickly (liquidity) Ignores cash flows beyond cutoff date Biased against long- term projects, e.g., R&D projects Important for small business 60

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