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 $896.74 $240 $10 $10 Project L -$1,000 $0 $240 $400 $792.04 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

Better is the one that has higher NPV

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

NPV of project S = -1,000 + 896.74 / (1 + 0.105)¹ + 240 / (1 + 0.105)² + 10 / (1 + 0.105)³ + 10 / (1 + 0.105)⁴

NPV of project S = $22.20

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

NPV of project L = -1,000 + 0 / (1 + 0.105)¹ + 240 / (1 + 0.105)² + 400 / (1 + 0.105)³ + 792.04 / (1 + 0.105)⁴

NPV of project L = $24.27

Better project is project L as it has the higher NPV

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

NPV of project L = -1,000 + 0 / (1 + R)¹ + 240 / (1 + R)² + 400 / (1 + R)³ + 792.04 / (1 + R)⁴

Using trial and error method, i.e., after trying various values for R, lets try R as 11.30%

NPV of project L = -1,000 + 0 / (1 + 0.113)¹ + 240 / (1 + 0.113)² + 400 / (1 + 0.113)³ + 792.04 / (1 + 0.113)⁴

NPV of project L = 0

Therefore, IRR of better project is 11.30%