NPV Rankings Depend on the Cost of Capital

Figure 7-4 shows that the NPV profiles of both Project L and Project S decline as the cost of capital increases. But notice in the figure that Project L has the higher NPV at a low cost of capital, while Project S has the higher NPV if the cost of capital is greater than the 7.2 percent crossover rate. Notice also that Project L's NPV is "more sensitive" to changes in the cost of capital than is NPVS; that is, Project L's net present value profile has the steeper slope, indicating that a given change in r has a greater effect on NPVl than on NPVS.

Recall that a long-term bond has greater sensitivity to interest rates than a short-term bond. Similarly, if a project has most of its cash flows coming in the early years, its NPV will not decline very much if the cost of capital increases, but a project whose cash flows come later will be severely penalized by high capital costs. Accordingly, Project L, which has its largest cash flows in the later years, is hurt badly if the cost of capital is high, while Project S, which has relatively rapid cash flows, is affected less by high capital costs. Therefore, Project L's NPV profile has the steeper slope.

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Responses

  • Sanna-Leen
    Does npv rely on the cost of capital?
    7 years ago

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