101 Concepts for the Level I Exam

Concept 60: NPV Profile

NPV profile shows the sensitivity of a project’s NPV for different discount rates. It is plotted on a graph where NPVs are on the y-axis with the discount rates on the x-axis.

Crossover rate is the discount rate at which the NPVs of both the projects are equal. The differences in timings of cash flows cause the two profiles to intersect and crossover.
Both NPV profiles intersect x axis where their NPVs are 0 i.e. at their IRRs.
In the above NPV profile, if Project I and Project D are mutually exclusive projects, for discount rates greater than 10%, Project D should be selected while for discount rates less than 10%, project I should be selected.

Comparison between NPV and IRR method

NPV method

IRR method

Advantages:

· Direct measure of expected increase in value of the firm.

· Produces theoretically correct decisions for unconventional cash flows.

Advantages:

· Gives percentage return on each dollar invested.

· Direct comparison with the cost of capital.

Disadvantages:

· Ignores project size. (Profitability Index overcomes this drawback.)

Disadvantages:

· Conflicting rankings that are different from NPV analysis for mutually exclusive projects. (Choose the project with higher NPV.)

· Projects with unconventional cash flow pattern can have multiple IRRs or no IRR.

· Unrealistically assumes that the money is reinvested at IRR rates.

For mutually exclusive projects, the NPV and IRR methods can have conflicting results due to the differences in project size or timings of cash flows. In such a case, always select project using NPV method. For independent projects, both NPV and IRR analysis yields the same decision.