Question

Year                          A                            B

                                0                              -8,000                    -8,000

                                1                              4,500                     1,900

                                2                              4,200                     3,000

                                3                              1,800                     4,000

                                4                              1,600                     5,000

What is the cross-over rate of the above two projects? Explain the significance of this rate.

Answer 1

Initial Cash Investment = $8000-8000

= 0

Year 1 Cash Flow = 1900-4500

= - $ 2600

Year 2 Cash Flow = $3000-4200

= - $ 1200

Year 3 Cash Flow = $4000-1800

= $ 2200

Year 4 Cash Flow = $ 5000-1600

= $ 3400

Based on the above calculations, IRR =

0=-2600/ (1.0x)-1200/(1.0x)^2 + 2200/ (1.0x)^3+3400/ (1.0x)^4

Hence, x= 18.461%

Cross Over Rate = 18.461%

The cross over rate is the discount rate at which the two projects have the same Net present Value. This rate is important as it helps to identify which product would be more beneficial in terms of risks when they have the same Net Present Value.