Capital Budgeting (Corporate Finance)

neha.kapoor318
Posts: 9
Joined: Sat Jun 07, 2014 7:14 am

Capital Budgeting (Corporate Finance)

Postby neha.kapoor318 » Sun Jun 08, 2014 3:42 am

Q2. An investment has an outlay of 100 and after tax cash flows of 40 annually for four years. A project enhancement increases the outlay by 15 and the annual after tax cash flow by 5 . As a result the vertical intercept of the NPV profile of the enhanced project shifts? can you please explain why the vertical intercept of the NPV profile of the enhanaced project shifts up and the horizontal intercept shift left up and the horizontal intercept shift right down and the horizontal intercept shiftsleft.?

edupristine
Finance Junkie
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Joined: Wed Apr 09, 2014 6:28 am

Capital Budgeting (Corporate Finance)

Postby edupristine » Mon Jun 09, 2014 6:20 am

NPV profile’s horizontal intercept is determined by IRR. Higher IRR will shift horizontal intercept to the right and lower IRR will shift the horizontal intercept to the left.
So, you need to have an idea of IRR for the original investment project and the project enhancement.

the original cash flows are 40/100 = 0.40 on an annual basis. The enhancement cash flows , considered as a separate project will return 5/15 or 33%.

So, mixing the two projects will result in an IRR which is lower than the original one. This moves the horizontal axis intercept to the left.

Vertical intercept represents NPV calculated with zero discount rate.

If discount rate is zero, -15 ouflow and +20 (i.e. 5 X 4 years) inflow will result in net +5 inflow.

Thus NPV has increased and this shifts vertical intercept up.


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