Question

“Bankrupt” Corporation is in a deep financial crisis. You are one of the financial avengers “Bankrupt” is desperately seeking help from. CEO of the company informed you that he is considering the two risky projects “Thanos” and “Loki” to protect the firm from financial collapse. Both projects have similar risk characteristics. Bankrupt’s WACC is 11%. The initial investments for both the projects are $200 million. Cashflow from the projects are as follows;

Year           1                2                3                4

Thanos       10M           60M           80M           160M

Loki           70M           50M           20M           160M

Now, your job is to explain the following questions in great detail so that the CEO understands your plans to protect the firm.

1. Explain your decision when Thanos and Loki are mutually exclusive, and when they are independent.
2. WACC has increased to 15%. What change you will see in NPV?
3. What is IRR and how it is different from NPV? What is the IRR for Thanos and Loki? Based on IRR which project you should accept?
4. How is IRR identical to Bond’s YTM?

Answer 1

i
WACC = 11%
Year	0	1	2	3	4	NPV
Thanos		10	60	80	160
Present Value	-200	10/(1.11)^1 = 9.01	60/(1.11)^2 = 48.7	80/(1.11)^3 = 58.5	160/(1.11)^4 = 105.4	-200+9.01+48.7+58.5+105.4 = 21.6
Loki		70	50	20	160
Present Value	-200	70/(1.11)^1 = 63.06	50/(1.11)^2 = 40.58	20/(1.11)^3 = 14.62	160/(1.11)^4 = 105.4	-200+63.06+40.58+14.62+105.4 = 23.66
If Thanos and Loki are mutually exclusive projects then we will select Loki as it has higher NPV than Thanos
If Thanos and Loki are independent projects then we would select both the projects as they both have positive NPV
ii
If WACC changes to 15%
Year	0	1	2	3	4	NPV
Thanos		10	60	80	160
Present Value	-200	10/(1.15)^1 = 8.7	60/(1.15)^2 = 45.37	80/(1.15)^3 = 52.60	160/(1.15)^4 = 91.48	-200+8.7+45.37+52.60+91.48 = - 1.85
Loki		70	50	20	160
Present Value	-200	70/(1.15)^1 = 60.87	50/(1.15)^2 = 37.81	20/(1.15)^3 = 13.15	160/(1.15)^4 = 91.48	-200+60.87+37.81+13.15+91.48 = 3.31
iii
IRR stands for internal rate return it is a rate at which NPV of project becomes zero, It means if the WACC exceeds that rate then the NPV would
be negative. So company have to keep its WACC lower than the IRR. NPV is the utility of time value money it gives us idea of what is the worth
of projects future cash flows in todays date.
IRR for Thanos is 14.66%
IRR for Loki is 15.71%
Higher the IRR is better as it provides high margin of safety, Hence we will select project Loki on the basis of IRR
Workings of IRR
Year	0	1	2	3	4	NPV
Thanos		10	60	80	160
	-200	10/(1.1466)^1 = 8.72	60/(1.1466)^2 = 45.64	80/(1.1466)^3 = 53.07	160/(1.1466)^4 = 92.57	-200+8.72+45.64+53.07+92.57 = 0
Loki		70	50	20	160
	-200	70/(1.1571)^1 = 60.50	50/(1.1571)^2 = 37.34	20/(1.1571)^3 = 12.91	160/(1.1571)^4 = 89.26	-200+60.50+37.34+12.91+89.26 = 0
iv
IRR & YTM both are the applications of time value of money, they both are calculated to decide whether the investments is worth doing or not. Based upon the concept of the time value of money, YTM is discount rate at which the current value of all future payments would be equal to the present cost of the bond, that means the NPV is equals to zero for bond and this same logic is applied to the project that present value of future cash flows if discounted at IRR would be same as initial cost which results in zero NPV.