Question

Kosovski Company is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and are not repeatable. If the decision is made by choosing the project with the higher IRR, how much value will be forgone? Note that under some conditions choosing projects on the basis of the IRR will cause $0.00 value to be lost.

WACC: 7.75

CFs Y0: $-1050 Y1 $675 $650

CFl Y0 $-1050 Y1 $360 Y2 360 Y3$360 Y4 $360

A.$11.45

B.$12.72

C.$14.63

D. $16.82

E. $19.35

Answer 1

WACC = 7.75%

Project S:

Year	Cash Flows
0	$-1050
1	$675
2	$650

NPV of Project S:-

NPVs = -CF(Y0) + PVCF(Y1) + PVCF(Y2) {PVCF = Present Value of Cash Flow at respective Years(Yi)}

= -1050 + 675/(1.0775) + 650/(1.0775^2)

= -1050 + 626.45 + 559.86 = $136.31(approx)

IRR of Project S:

Through Excel Function =IRR(Input Values):- 17.13%

For reference for IRR function:

Project L:

Year	Cash Flows
0	$-1050
1	$360
2	$360
3	$360
4	$360

NPV of Project L:-

NPVL = -CF(Y0) + PVCF(Y1) + PVCF(Y2) +PVCF(Y2) +PVCF(Y2) {PVCF = Present Value of Cash Flow at respective Years(Yi)}

= -1050 + 360/(1.0775) + 360/(1.0775^2) + 360/(1.0775^2) + 360/(1.0775^2)

= -1050 + 334.1067 + 310.0758 + 287.7734 + 267.0751 = $149.031(approx)

Through Excel Function =IRR(Input Values):- 13.95%

So, as it can be seen that Project S has higher IRR as compared to Project L. Therefore the Value Loss can calculate as the difference of NPV:

Value loss= NPVs - NPVL =  $136.31 - $149.031 = $12.72(approx)

So, Option B seems apt answer for this question.