Question

The crossover rate is an important concept in capital budgeting and provides information when choosing between two mutually exclusive projects. Which of the following statements best represents what the crossover rate is?

A. The crossover rate is the point or interest rate on the Net Present Value Profile at which the net present values of two projects are equal. To the left of this point, when the cost of capital is less than the crossover rate, the internal rate of return gives better information to the firm than the net present value. So, the firm will use the internal rate of return to decide which project to undertake. The better project will be the one with the higher internal rate of return.
B. The crossover rate represents a safety margin. It gives the percentage, or rate of return, that can be expected from a project relative to its cost.
C. The crossover rate is the point or interest rate on the Net Present Value Profile at which the net present values of two projects are equal. To the right of this point, when the cost of capital is greater than the crossover rate, both the net present value and the internal rate of return will give the firm the same decision about the project.
D. The crossover rate is the minimum rate of return on a common stock that a stockholder considers acceptable.
E. The crossover rate is the discount rate at which the present value of a project's cost is equal to the present value of its terminal value, where the terminal value is found as the sum of the future values of the cash inflows, compounded at the firm's cost of capital

Answer 1

The crossover rate is a point on the Net Present Value Profile where two projects' NPVs are equal and typically influences project selection differently at various costs of capital. The correct answer is option A.

Step-by-step explanation:

The crossover rate is an essential concept in capital budgeting when comparing two mutually exclusive projects. Statement A is the correct definition: The crossover rate is the point or interest rate on the Net Present Value Profile at which the net present values of two projects are equal. To the left of this point, when the cost of capital is less than the crossover rate, one project might appear more favorable than the other based on the internal rate of return (IRR). However, as the cost of capital increases beyond the crossover rate, differences in timing and scale of the cash flows can lead to different NPV profiles, often leading to the same project selection regardless of whether you're using IRR or NPV methodologies for capital budgeting decisions.