Question

Tesar Chemicals is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO believes the IRR is the best selection criterion, while the CFO advocates the NPV. If the decision is made by choosing the project with the higher IRR rather than the one with the higher NPV, how much, if any, value will be forgone, i.e., what's the chosen NPV versus the maximum possible NPV? Note that (1) "true value" is measured by NPV, and (2) under some conditions the choice of IRR vs. NPV will have no effect on the value gained or lost.


WACC: 7.00%

0 1 2 3 4

CF_S -$1,100 $550 $600 $100. $100

CF_L -$2,700 $650 $725 $800 $1,400

Answer 1

Given that WACC is 7%.

Calculating NPV of project S, we get -1100+550/1.07+600/1.07^2+100/1.07^3+100/1.07^4= 96

Calculating NPV of project L, we get -2700+650/1.07+725/1.07^2+800/1.07^3+1400/1.07^4= 261.81

Calculating IRR of project S, Let r be the IRR. we get -1100+550/1+r+600/(1+r)^2+100/(1+r)^3+100/(1+r)^4= 0. On solving, we get r= 12.24%

Calculating IRR of project L, Let r be the IRR. we get -2700+650/1+r+725/(1+r)^2+800/(1+r)^3+1400/(1+r)^4= 0. On solving, we get r= 10.71%

So, if the decision is made by choosing the project with higher IRR, we will choose project S. Then value forgone will be NPV of project L-NPV of project S= 261.81-96= 165.81.

So, value foregone is $165.81