NPV profile is a graphical representation of sensitivity of the project’s value to the change in discount rates. As discounting rate increases, the present value of the project drops proportionally.
The graph shows the value drop with the increase in discount rates. Discount rates are the returns expected from the project over the period of operation and ability to generate cash. Determining projects on the basis of three parameters:
Crossover rate is the point at which two projects have same net present value, in other words the discounting rate, which brings their value together and become net zero. When projects are discounted at this rate, the management is helpless in choosing among them both. This can be a situation with mutually exclusive projects based on the value added to the firm, leaving the product competence behind.
For a management to decide which project to be taken for execution, determining the discount rate followed by the certainty of predicting the cashflow of the project. Cash flows for a matured business can be accurately estimated as the management has the historical data that are adjusted for errors and the expertise needed for the project to match the forecasts with the real cash flows.
On the profile D(A) is the discount rate used, the determined discount rate falls above the crossover point the Project A should be executed. If the discount rate falls below the crossover intersection D(B), Project B should be executed or both the projects can be dropped because projects chosen struggles to earn profits more than the cost of capital. This way value added to the company is minimal for the efforts taken. The reason why project B has a less steeper profile is, the majority of cash flow is generated in the later period of the project.
The profile aids only in choosing between projects and not individual valuation.