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? Interest rate: 10.00% Year 0 1 2 3 4 CFS -$1,000 $380 $380 $380 $380 CFL -$2,100 $765 $765 $765 $765

Answer 1

Solution:

The IRR of project S = 19.14 %

The IRR of project L = 16.97 %

The NPV of project S = $ 204.5489

The NPV of project L = $ 324.9471

The project with higher IRR is Project S with IRR of 19.14 %.

Thus if project S is chosen, the NPV to the company will be $ 204.5489, which is lesser than the NPV of the Project L at

$ 324.9471 with an IRR of 16.97 %

Since these projects are mutually exclusive, equally risky, and not repeatable the NPV method should be used as the decision criterion. Since the NPV of Project L is greater than that of Project S, Project L should be chosen,

If the decision is made by choosing the project with the higher IRR rather than the one with the higher NPV, the value that will be forgone = $ 324.9471 - $ 204.5489

= $ 120.3982

= $ 120.40 ( When rounded off to two decimal places )

Thus the potential value the firm would lose if the wrong decision criterion of IRR is used is = $ 120.40

Please find the attached screenshot of the excel sheet containing the detailed calculation for the solution.