Question

Why is the NPV of a relatively long-term project (one for which a high percentage of its cash flows occurs in the distant future) more sensitive to changes in the WACC than that of a short-term project?

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The NPV of a relatively long-term project for which the majority of the cash flows occurs in the distant future is more sensitive to changes in the discount rate or WACC than that of a short-term project because of the effect of the WACC in the present value of the distant cash flows. The longer the period, the bigger the effect of discounting. Since majority of the cash flows are in the distant future, any changes in the discount rate will have more effect. In other words, it is more exposed to price risk.

If you will remember the bond topic, bonds with longer maturity period are more exposed to price risk than bonds with shorter maturity period. This applies also to NPVs of longer term projects.

Refer to page 245 for details.

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