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 $868.78 $260 $15 $10 Project L -$1,000 $5 $240 $380 $812.00 The company's WACC is 10.5%. 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

Project S:

NPV = Present value of cash inflows - present value of cash outflows

NPV = -1000 + 868.78 / ( 1 + 0.105)¹ + 260 / ( 1 + 0.105)² + 15 / ( 1 + 0.105)³ + 10 / ( 1 + 0.105)⁴

NPV of project S = $16.99

Project L:

NPV = Present value of cash inflows - present value of cash outflows

NPV = -1000 + 5 / ( 1 + 0.105)¹ + 240 / ( 1 + 0.105)² + 380 / ( 1 + 0.105)³ + 812.00 / ( 1 + 0.105)⁴

NPV of L= $27.36

When two projects are mutuall exclusive, we check the NPV for choosing the better project. Here the better project is L as it has a higher NPV.

IRR of project L:

IRR is the rate of return that makes NPV equal to 0

NPV = -1000 + 5 / ( 1 + R)¹ + 240 / ( 1 + R)² + 380 / ( 1 + R)³ + 812.00 / ( 1 + R)⁴

Using trial and error method, i.e, after trying various values for R, let's try R as 11.4%

NPV = -1000 + 5 / ( 1 + 0.114)¹ + 240 / ( 1 + 0.114)² + 380 / ( 1 + 0.114)³ + 812.00 / ( 1 + 0.114)⁴

NPV = 0

Therefore IRR of better project L is 11.5%