Question

A company is analyzing two mutually exclusive projects, S and L, with the following cash flows: 0 1 2 3 4 Project S -$1,000 $885.08 $260 $5 $5 Project L -$1,000 $5 $250 $400 $846.78 The company's WACC is 8.0%. What is the IRR of the better project? (Hint: The better project may or may not be the one with the higher IRR.) Round your answer to two decimal places. %

Answer 1

Let’s calculate Net present value (NPV) & Internal rate of return (IRR) of project

Where,

The formula for NPV is:

Net present value (NPV) of Project = Sum of [net cash inflows/ (1+r) ^t] - initial cash outflow

Where,

The weighted average cost of capital (WACC) r =8%

And time period t = 1, 2, 3, 4

Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows from an investment equal zero.

The formula for IRR is:

0 = C0 + C1/ (1+IRR) ^1 + C2/ (1+IRR) ^2+ C3/ (1+IRR) ^3 + C4/ (1+IRR) ^4

Where C0, C1, C2, C3, C4, are the cash flows for the respective periods 0, 1, 2, 3, 4

NPV & IRR calculation in excel:

Year (n)	Net cash flow of Project S (CF)	PV = CF/(1+WACC%)^n	Net cash flow of Project L (CF)	PV = CF/(1+WACC%)^n	Formula used for PV
0	-$1,000	-$1,000.00	-$1,000.00	-$1,000.00	CF/(1+8%)^0
1	$885.08	$819.52	$5.00	$4.63	CF/(1+8%)^1
2	$260	$222.91	$250.00	$214.33	CF/(1+8%)^2
3	$5	$3.97	$400.00	$317.53	CF/(1+8%)^3
4	$5	$3.68	$846.78	$622.41	CF/(1+8%)^4
IRR	12.39%		12.89%
NPV (sum of PVs)		$50.07		$158.91

The NPV of the both projects are positive but project L has higher NPV ($158.91) therefore it is more attractive and can be accepted.

As the IRR is more than the WACC for both projects but project L has higher IRR (12.89%) therefore it is better and should be accepted.

Formulas used in excel: