What is the crossover rate in capital budgeting, and how does an NPV profile help you understand it? The crossover rate is the discount rate beyond which the net present value ranking flips when comparing two projects in capital budgeting. In the example that we explore in this video, we will see that for discount rates from 0% to 19%, the net present value of project A exceeds the net present value of project B, so you would prefer A over B when making an investment decision. However, for discount rates above 19%, the net present value of project A is lower than the net present value of project B! You would now prefer B over A. The ranking flips. How can this happen? Calculating and visualizing the crossover rate and building an NPV profile will help us understand this phenomenon.

⏱️TIMESTAMPS⏱️
0:00 Crossover rate definition
0:57 Comparing cash flow profiles
2:47 Calculating the crossover rate
4:41 NPV profile
4:58 NPV profile in Excel
6:59 Crossover rate in the NPV profile
7:33 NPV profile graph
8:16 Crossover rate graph
8:52 IRR in the NPV profile graph
9:37 NPV vs IRR which is better

So how do you calculate the crossover rate? You simply need to find the Internal Rate of Return (IRR) of the difference in cash flows between two projects.

A common way to see the crossover rate in a bigger perspective is to build an NPV profile. An NPV profile shows the sensitivity of a project's NPV for different discount rates.

It’s easier to grasp that, when we visualize the NPV profile and the crossover rate in a graph. Discount rate on the horizontal axis, net present value on the vertical axis. The NPV of project A as a function of the discount rate is shown as an orange line, the NPV of project B as a blue line. For both projects, the higher the discount rate (the further we go to the right), the lower the net present value. The NPV of project A is much higher than that of project B at low discount rates, which means that if you had to select one of these two projects for investment at any of those lower discount rates, then project A would be preferred. However, that NPV gap shrinks the further you go to the right, until the NPVs are equal at the crossover rate of 19%. Beyond the crossover rate of 19%, even though the NPVs are getting fairly low or even negative in absolute terms, the NPV of project B is higher than the NPV of project A, which means that if you had to select one of these two projects for investment, project B would be preferred at those higher discount rates.

The graph of the NPV profile gives us some additional information. What are the respective discount rates that make the NPV of the projects equal to zero? In other words, what are their IRRs? For project A, the IRR is 21.9%, that’s where the orange line intersects the horizontal axis. For project B, the IRR is 23.4%, that’s where the blue line intersects the horizontal axis. So while the IRR for project B is higher than that of project A, the NPV of project A is higher than that of project B for discount rates up to 19%. Only for cases where the discount rate is higher than 19%, do NPV and IRR both suggest to favor project B. When in doubt, NPV is more important than IRR in #capitalbudgeting . If NPV and IRR don’t point you in the same direction of which project you should select, then apply #crossoverrate analysis to understand the NPV profiles!

Philip de Vroe (The Finance Storyteller) aims to make accounting, finance and investing enjoyable and easier to understand. Learn the business and accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better investing decisions. Philip delivers #financetraining in various formats: YouTube videos, classroom sessions, webinars, and business simulations. Connect with me through Linked In!

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