“Net Present Value(NPV)Profile”

Ramesh PantBBM-18

Fourth Semester

Financial Management

NPV Profile

• A net present value profile is a graphic representation of the net present value of a project at various discount rates.

• The net present value profile may be used when conflicting rankings of projects exist by depicting each project as a line on the profile and determining the point of intersection.

• If the intersection occurs at a positive discount rate, any discount rate below the intersection will cause conflicting rankings, whereas any discount rates above the intersection will provide consistent rankings.

• Conflicts in project rankings using NPV and IRR result from differences in the magnitude and timing of cash flows.

• Projects with similar-sized investments having low early-year cash inflows tend to be preferred at lower discount rates.

• At high discount rates, projects with the higher early-year cash inflows are favored, as later-year cash inflows tend to be severely penalized in present value terms.

• The net present value profile allows for the graphic representation of the net present value of a project at different discount rates.

• Net present values are shown along the vertical axis and discount rates are shown along the horizontal axis.

NPV ProfilesExample: Draw the NPV profiles of the two projects. Show the values where

the NPV profiles intersect the vertical axis and the horizontal axis.

Internal Rate of Return (IRR)

• The internal rate of return (IRR) is that discount rate that causes the NPV of the project to equal zero.

• If IRR > WACC, then the project is acceptable because it will return a rate of return on invested capital that is likely to be greater than the cost of funds used to invest in the project.

IRR versus NPV

• Both methods use the same basic decision inputs.

• The only difference is the assumed discount rate.• The IRR assumes intermediate cashflows are

reinvested at IRR…NPV assumes they are reinvested at WACC– This difference, however, can produce conflicting

decision results under specific conditions

Comparing NPV and IRR

• Both techniques use the same inputs• NPV measures in absolute terms, the estimated increase in

the value of the firm today the project is expected to produce.– NPV assumes cash flows are reinvested at WACC

• IRR estimates the rate of return on the project– IRR assumes cash flows produced by the project are reinvested

by the firm at the project’s IRR.

The reason for the different accept/reject decisions is the different reinvestment rate assumptions used by the two

techniques.

Thanks !