Question

Royal Inc. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with the higher IRR, how much value will be forgone? Note that under certain conditions choosing projects on the basis of the IRR will not cause any value to be lost because the project with the higher IRR will also have the higher NPV, so no value will be lost if the IRR method is used. WACC: 10.25% Year 0 1 2 3 4 CFS -$4,100 $1,500 $1,520 $1,540 $1,560 CFL -$8,600 $3,000 $3,036 $3,072 $3,108 A. Value lost if use the IRR criterion: $298.71. B. Value lost if use the IRR criterion: 0 C. Value lost if use the IRR criterion: $119.79 D. Value lost if use the IRR criterion: $149.36

Answer 1

Irr of project 1:

-4100+1500/(1+IRR)+1520/(1+IRR)^2+1540/(1+IRR)^3+1560/(1+IRR)^4=0

=>IRR=18.06%

IRR of Project 2: -8600+3000/(1+IRR)+3036/(1+IRR)^2+3072/(1+IRR)^3+3108/(1+IRR)^4=0

=>IRR=15.58%

Hence, according to IRR criterion, we will choose Project 1

NPV of Project 1=-4100+1500/1.1025+1520/1.1025^2+1540/1.1025^3+1560/1.1025^4=716.09

NPV of Project 2=-8600+3000/1.1025+3036/1.1025^2+3072/1.1025^3+3108/1.1025^4=1014.80

Hence, we should have chosen Project 2 but we chose Project 1 so value lost=1014.80-716.09=298.71

Option A