A firm is considering Projects S and L, whose cash flows are shown below. These

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 $1,025 $380 $380 $2,150 $765 $765 2 CFS CFL $380 $765 4 $380 $765 a. $182.74 b. $214.44 c. $220.03 d. $186.47 e. $218.17

Explanation / Answer

The Potential Value that the firm would lose is “d. $186.47”

Net present Value – Project S

Net Present Value [NPV] = Present Value of cash Inflows – Initial Investment

= $380[PVIFA 6.75%, 4 Years] - $1,025

= [$380 x 3.4064160] - $1,025

= $ 1,294.44 - $1,025

= $ 269.44

Net present Value – Project L

Net Present Value [NPV] = Present Value of cash Inflows – Initial Investment

= $765[PVIFA 6.75%, 4 Years] - $2,150

= [$765 x 3.406416065] - $2,150

= $ 2605.91 – 2,150

= $ 455.91

“Potential Value of loss = $455.91 – 269.44 = $186.47”

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