NPV Profile Meaning
Net present value (NPV) profile of the company refers to the graph which shows the net present value of the project under consideration with respect to the corresponding various different rate of the discount where net present value of the project is plotted on the Y-axis of the graph and the rate of the discount is plotted on the X-axis of the graph.
The relationship between the discount rate and NPV is inverse. When the discount rate is 0%, the NPV profile cuts the vertical axis. NPV profile is sensitive to discount rates. Higher discount rates indicate the cash flows occurring sooner, which are influential to NPV. The initial investment is an outflow as it is the investment in the project.
The following are components of NPV Profile
- Internal Rate of Return (IRR): The rate of return, which does the projects NPV is zero, is called as IRR. It is one of the important factors while considering a profitable project.
- Crossover Rate: When two projects have the same NPV, i.e., when the NPV of two projects intersects each other, it is called a crossover rate.
If two projects are mutually exclusive, the discount rate is considered as the deciding factor to differentiate between the projects.
Steps to Prepare the NPV Profile
Consider there are two projects. To build an NPV profile, these steps have to be considered
- Step 1 – Find the NPV of both projects at 0%.
- Find the NPV for project A
- Find the NPV for project B
- Step 2 – Find the Internal Rate of Return (IRR) for both projects.
- Find the IRR for Project A
- Find the IRR for Project B
- Step 3 – Find the crossover point
- If the NPV is greater than zero, than accept the investment
- If the NPV is lower than zero, than reject the investment
- Of the NPV is equal to the investment, then it is marginal
These rules are applicable when it is assumed that the company has unlimited cash and time to accept all projects that come in their way. However, it is not true in the real world. The companies usually have limited resources and have to select a few of the many projects.
Let us understand this better by looking at an example.
Consider project A which requires an initial investment of $400 million. This project is expected to generate cash flows of $160 million for the next four years.
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Consider another project B, which requires an initial investment of $400 million and no cash flows in the next three years and $800 million in the last year.
To understand how sensitive these cash flows are to the cash flows, let us consider multiple discount rates – 0%, 5%, 10%, 15%, 18.92%, and 20%
The net present value of these cash flows can be determined using these rates. This is shown below in a tabular format below.
|Discount Rate||NPV for Project A||NPV for Project B|
Another important point to be considered is that if Project Y is taken up at higher rates, than the project will have a negative NPV and therefore be unprofitable
(Please note that there are various ways to calculate NPV(Net Present Value) Profile like the formula method, Financial calculator, and excel. The most popular method is the excel method)
Plotting this NPV Profile on a graph will show us the relationship between these projects. Using these points, we can also calculate the crossover rate, i.e., the rate at which the NPV of both projects is equal.
The following graph is the NPV profile of project A and Project B.
As discussed above, somewhere around 15% is the crossover rate. This is depicted in the graph where the two lines of Project A and Project B meet.
For Project B, 18.92% is the rate that makes the NPV of the project zero. This rate is known as the internal rate of return. As in the graph, this is where the line crosses the X-axis.
Looking at the different NPV (Net Present Value) profile values, it is conveyed that Project A performs better at 18.92% and 20%. On the other hand, Project Y performs better at 5%, 10% as well as 15% as the discount rate increases the NPV declines. This is also true in the real world when the discount rate increases, the business has to put more money into the project; this increases the cost of the project. The steeper the curve, the more the project is sensitive to interest rates.
Consider a scenario where there are two projects which are mutually exclusive. In this case, the discount rate becomes the deciding factor. In our above example, when the rates are lower, project B performs better. Lower rates are to the left of the crossover rate.
On the other hand, project A performs better at higher rates. That is on the right side of the cross over-rate
Where are NPV Profiles Used?
NPV(Net Present Value) profiles are used by the companies for capital budgeting. Capital budgeting is the process that the business uses to decide which investments are profitable. The motive of these businesses is to make profits for their investors, creditors, and others. This is only possible when the investment decisions they make results in increasing the equity. Other tools used are IRR, profitability index, payback period, discounted payback period, and accounting rate of return.
The net present value mainly measures the net increase in the company’s equity by working on a project. It is essentially the difference between the present value of cash flows and the initial investment based on the discount rate. The discount rate is mainly decided on the basis of the debt and equity mix used to finance the investment and to pay for the debt. It also incorporates the risk factor, which is inherent in the investment. Projects with positive NPV profile are considered the ones which maximize the NPV and are the ones selected for investment.
This has been a guide to NPV Profile. Here we discuss the NPV Profile components, rules for acceptance, and rejection along with practical examples and uses. You can learn more about financing from the following articles –