Saturday, December 1, 2012

Cross-Over Rate in Corporate Finance ---> Choosing between 2 mutually exclusive projects

From the link:

When comparing two different but similar projects, the specific returns required for the projects to have the same net present value. Because two similar securities may have different volatility, calculating the crossover rate helps to determine which will be more profitable in the short and long terms. For example, one dot-com company may achieve a steady rate of growth, but only slowly over time, while a second dot-com may achieve the same returns in a shorter time-frame, but with greater vulnerability to market downturns. Calculating the rate at which each will achieve a desired net present value, assuming no massive changes in circumstances, may help an investor make decisions regarding which to buy and which to sell.

How to calculate the Cross-Over Rate:

From the link:

Calculating a crossover rate can help you plan ahead when making certain business decisions. A crossover rate can help you determine how to manage your business investments in multiple securities, and it can also help you manage funding for projects and prepare reports for investor-relations documents. Most important, a crossover rate can be used to choose between different investment strategies, projects or securities, as it can be used to indicate which choice can be the most profitable for a business.
  • Organize your cash-flow data from the two projects. Ensure that the periods match up and are of equal length. Calculate the differences in cash flow for each period between the first and second projects by subtracting each set of terms.
  • Type these differences into either an IRR calculator available on the Internet, or the standard IRR formula: 0 = - outlay + DCF1/(1+r)^1 + DCF2/(1+r)^2 +(etc)+ DCFn/(1+r)n, where outlay stands for the initial investment, DCF1 stands for first difference in cash flow, and DCFn stands for the last cash-flow difference period.
  • Press "Calculate" on the IRR calculator, or type the completed equation into a calculator and press "Enter."
  • Round the generated value, which is either the output value of the online calculator or the term "r" in the formula. This will produce the crossover rate in terms of percentage.

SC NPV Profiles and Crossover Rates from Rick Mull on Vimeo.

1 comment:

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