Corporate Finance

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

Corporate Finance

Postby neha.kapoor318 » Mon Aug 11, 2014 3:03 pm

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 cash flows by 5. As a result , the vertical intercept of the NPV profile of the enhanced project shifts: The Answers for the questions are: A)Up and the horizontal intercept shifts left. B)Up and the horizontal intercept shifts right. C) Down and the horizontal intercept shifts left. Can u please expain me the this question and the outcome of this question?

The Correct answer is A.
The NPV profile basically shows the NPV of the project at different levels of discount rate. If the discount rate of the project is zero, and if we simply sum the cash flows we would get the vertical intercept of the NPV profile. In the question above the vertical intercept would increase from 60 to 65. The horizontal intercept measures the IRR as this is the rate at which NPV is zero. This intercept would move to the left in the question above. This can be seen by putting in the cash flow in the question into the calculator. IRR declines from 21.86% to 20.68%.

I got the answer from one of the faculty but have one doubt in the given solution regarding some of the calculation part i have mentioned the query below can u please clarify the doubt i have.

As you mentioned that the vertical intercept would increase from 60 to 65 can u please explain how will you get these figures i mean the calculation done for this. In addition to this also i am able to get first calculation of IRR that is 21.86% whereas i am not able to get IRR 20.68% how did you get this figure can please explain the calculation using financial calculator i am using BA II plus

pankaj
Finance Junkie
Posts: 61
Joined: Fri Aug 03, 2012 11:24 am

Corporate Finance

Postby pankaj » Thu Aug 14, 2014 10:40 am

Hi Neha,
In the above question discount rate is missing. so for better understanding lets assume discount rate to be 10% for both the scenario.
So, in your Financial calculator enter the given information
Scenario 1:
CF0 = -100
CO1 = 40
F01 = 4 (because the project will receive the same cashflow in all 4 year, i have entered the cashflow once (which is 40) and made the F01(represents year) to be 4. Otherwise, you could enter CO1 = 40, F01 = 1 ; C02 =40, F02 = 1 ; and so on)
I = 10
Compute for NPV and IRR
NPV = 26.79
IIR = 21.86%

Scenario 2:
CF0 = -115
CO1 = 45
F01 = 4
Compute for NPV and IRR
NPV = 27.64
IIR = 20.68%

In NPV profile, discount rates are on the X axis represents and corresponding NPVs are plotted on the Y axis.

And Remember, the project s IRRs are the discount rate where NPV profile intersect the X -axis.
Therefore, the NPV profile of the above two scenario can be seen using below link:
http://edupristine.s3.amazonaws.com/Cou ... /image.jpg

You can see in the image that NPV has moved up (vertically up) and IRR have moved to left (horizontally left).

Coming to you question of how 60 and 65 has come.
60 and 65 has come by taking discount rate as 0, which is fundamentally wrong. However, assuming zero discount rate will give NPV of 60 in scenario 1 and NPV of 65 in scenario 2 and will show upward movement vertically and left movement horizontally.
May be for the sake of solving this particular question the instructor has assumed discount rate as zero.

Note: Just by visualizing you can solve such kind of questions

Hope this helps!


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