Optical Illusion in the Comparison of NPV Profiles of Mutually Exclusive Projects

6 Pages Posted: 10 Aug 2017 Last revised: 24 Aug 2017

See all articles by Domingo Joaquin

Domingo Joaquin

Illinois State University - Department of Finance, Insurance and Law

Date Written: August 21, 2017

Abstract

In the comparison of NPV profiles of a pair of mutually exclusive projects, it is customary overlay the two NPV Profiles in a two dimensional graph with NPV on the vertical axis and discount rate horizontal axis. The project NPVs are then compared at each feasible discount rate. By having the horizontal axis represent one discount rate, the two potentially different project discount rates are effectively forced to be equal to each other. This leads to the identification of a crossover discount rate, below which one of the projects dominates, and above which the other project dominates. As a corollary, it is observed that, when the discount rate is below the crossover rate, project ranking in terms of the NPV is inconsistent with ranking in terms of IRR, but consistent with each other when the discount rate is higher than the crossover rate. However, such a characterization hinges crucially on the implicit assumption that the same discount rate is applied to both projects. This characterization falls apart when projects are allowed to have different discount rates. A series of examples is presented which demonstrates that much of the incorrect conjectures about dominance by one project over another can be avoided simply by explicitly incorporating the missing independent variables, a separate discount rate for each project, in the comparative analysis of the two NPV profiles.

Keywords: Capital Budgeting, NPV Profile, IRR, Corporate Finance

JEL Classification: G11, G31, G30

Suggested Citation

Joaquin, Domingo, Optical Illusion in the Comparison of NPV Profiles of Mutually Exclusive Projects (August 21, 2017). Available at SSRN: https://ssrn.com/abstract=3016178 or http://dx.doi.org/10.2139/ssrn.3016178

Domingo Joaquin (Contact Author)

Illinois State University - Department of Finance, Insurance and Law ( email )

Normal, IL 61790
United States
(309) 438-2258 (Phone)
(309) 438-5510 (Fax)

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