Question

Consider the following two mutually exclusive projects:

	Cash Flows ($)
Project	C0	C1	C2	C3
A	-$100	+$60	+$60	+$60
B	-$100	----	----	+$208.35

Calculate the NPV of each project for a discount rate of 14%.

What is approximately the IRR for each project individually?

Use the IRR cross-over method to determine which of the projects you should accept (describe the correct decision rule describing when you pick A versus B based on what discount rate).

Answer 1

NPV is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. Based on the NPV calculated for two projects in snapshot below, Project B should be accepted.

IRR is the discount rate at which NPV is zero. IRR for both projects is in snapshot below.

IRR cross over method or cross over IRR rate is calculated by calculating the IRR of the cash flows calculated as difference between the cash flows of 2 projects. If company's cost of capital crosses the crossover rate, the relative attractiveness of mutually-exclusive projects changes i.e. if first project is preferable at a discount rate below the crossover rate, second becomes feasible as soon as the cost of capital crosses the crossover rate.

In this case 15% is the cross over rate. If the discount rate is below 15%, Project B would be preferable. If discount rate is above 15%, Project A would be preferable.