Question

Oil Drilling Inc. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO believes the IRR is the best selection criterion, while the CFO advocates the MIRR. If the decision is made by choosing the project with the higher IRR rather than the one with the higher MIRR, how much, if any, value will be forgone. In other words, what's the NPV of the chosen project versus the maximum possible NPV? Note that (1) "true value" is measured by NPV, and (2) under some conditions the choice of IRR vs. MIRR will have no effect on the value lost. WACC: 7.00%

Year      0          1        2         3           4

CFS -$1,100   $550   $600   $100   $100

CFL -$2,750   $725   $725   $800   $1,400

Answer 1

The NPV of the chosen project versus the maximum possible NPV

The value to be forgone is the difference between the Net Present Value of the Project S and Project L

Net Present Value (NPV) – PROJECT S

Period	Annual Cash Flow ($)	Present Value factor at 7.00%	Present Value of Cash Flow ($)
1	550	0.93458	514.02
2	600	0.87344	524.06
3	100	0.81630	81.63
4	100	0.76290	76.29
TOTAL			1,196.00

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

= $1,196.00 - $1,000

= $196.00

Net Present Value (NPV) – PROJECT L

Period	Annual Cash Flow ($)	Present Value factor at 7.00%	Present Value of Cash Flow ($)
1	725	0.93458	677.57
2	725	0.87344	633.24
3	800	0.81630	653.04
4	1,400	0.76290	1,068.05
TOTAL			3,031.90

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

= $3,031.50 - $2,750

= $281.90

Therefore, the amount/value to be forgone = Net Present Value of Project L – Net Present Value of Project S

= $281.90 - $96.00

= $185.90

NOTE

The Formula for calculating the Present Value Factor is [1/(1 + r)ⁿ], Where “r” is the Discount/Interest Rate and “n” is the number of years.