Question

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?

WACC=8.75%

	Year 0	Year 1	Year 2	Year 3	Year 4
CFs	-$1100	$650	$500	$200	$50
CFl	-$2500	$650	$725	$800	$1400

Answer 1

IRR is the rate at which NPV of a project equals zero.

NPV = PV of future cash flow - Initial outlay

Project S:

Initial Outlay = 1100

IRR

0 = 650/(1+IRR)^1+ 500/(1+IRR)^2+ 200/(1+IRR)^3+ 50/(1+IRR)^4 - 1100

We will use heat and trial method to find that value of IRR which will make NPV =0

IRR = 15.21 % Answer

NPV

WACC = 8.75%

NPV =650/(1+0.0875)^1+ 500/(1+0.0875)^2+ 200/(1+0.0875)^3+ 50/(1+0.0875)^4 - 1100

NPV = $111.73 Answer

Project L:

IRR

Initial Outlay = 2500

0 = 650/(1+IRR)^1+ 725/(1+IRR)^2+ 800/(1+IRR)^3+ 1400/(1+IRR)^4 - 2500

We will use heat and trial method to find that value of IRR which will make NPV =0

IRR = 13.95% Answer

NPV

NPV = 650/(1+0.0875)^1+ 725/(1+0.0875)^2+ 800/(1+0.0875)^3+ 1400/(1+0.0875)^4 - 2500

NPV = $333.69 Answer

Based on Higher IRR criteria: Project S should be consider.

Value Forgone = $333.69 - $111.73 = $221.96 Answer