Question

A firm is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO wants to use the IRR criterion, while the CFO favors the NPV method. You were hired to advise the firm on the best procedure. If the wrong decision criterion is used, how much potential value would the firm lose? WACC: 6.75% 0 1 2 3 4 CFS -$1,025 $380 $380 $380 $380 CFL -$2,150 $765 $765 $765 $765 a. $218.17 b. $182.74 c. $186.47 d. $220.03 e. $214.44

Answer 1

Net Present Value (NPV) of Project - S

Year	Annual cash flows ($)	Present Value Factor (PVF) at 6.75%	Present Value of annual cash flows ($) [Annual cash flow x PVF]
1	380	0.936768	355.97
2	380	0.877535	333.46
3	380	0.822046	312.38
4	380	0.770067	292.63
TOTAL			1,294.44

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= $1,294.44 - $1,025

= $269.44

Net Present Value (NPV) of Project - L

Year	Annual cash flows ($)	Present Value Factor (PVF) at 6.75%	Present Value of annual cash flows ($) [Annual cash flow x PVF]
1	765	0.936768	716.63
2	765	0.877535	671.31
3	765	0.822046	628.87
4	765	0.770067	589.10
TOTAL			2,605.91

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= $2,605.91 - $2,150

= $455.91

Therefore, the Difference between the NPV of these two Project is $186.47 [$455.91 - $269.44]

“Hence, the Potential Value that the firm lose will be (c). $186.47”

NOTE

-The formula for calculating the Present Value Annuity Inflow Factor (PVIFA) is [{1 - (1 / (1 + r)ⁿ} / r], where “r” is the Discount Rate and “n” is the number of years.