Moerdyk & Co. is considering Projects S and L, whose cash flows are shown below.

Question

Moerdyk & Co. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with the higher IRR, how much value will be forgone? Note that under certain conditions choosing projects on the basis of the IRR will not cause any value to be lost because the one with the higher IRR will also have the higher NPV, i.e., no conflict will exist.

WACC:

10. 00%

0

1

2

3

4

CFS

-$1,025

$650

$450

$250

$50

CFL

-$1,025

$100

$300

$500

$700

WACC:

10. 00%

0

1

2

3

4

CFS

-$1,025

$650

$450

$250

$50

CFL

-$1,025

$100

$300

$500

$700

Explanation / Answer

Internal rate of return is the rate at which the NPV of an investment is zero and the investment with higher NPV should be accepted if chosing from two mutualy excluive and equally risky projcts

For Project S

Initial investment = $1025 and cash flows are $650 $450 $250 and $50 respectively.

given WACC = 8%

Going by the trial and Error method, Find the IRR where NPV becomes Nearly zero

0 = 650/(1+0.18)^1+450/(1+0.18)^2+250/(1+0.18)^3+50/(1+0.18)^4 - 1025 = 26.98

0 = 650/(1+0.19)^1+450/(1+0.19)^2+250/(1+0.19)^3+50/(1+0.19)^4 - 1025 = 12.36

0 = 650/(1+0.20)^1+450/(1+0.20)^2+250/(1+0.20)^3+50/(1+0.20)^4 - 1025 = -2.04

Thus for project S , IRR would be 19 % where NPV is nearly zero and is even greater than WACC of 8%

For Project L

Initial investment = $1025 and cash flows are $100 $300 $500and $700 respectively

given WACC = 8%

Going by the trial and Error method, Find the IRR where NPV becomes Nearly zero

0 = 100/(1+0.14)^1+300/(1+0.14)^2+500/(1+0.14)^3+700/(1+0.14)^4 - 1025 = 45.50

0 = 100/(1+0.15)^1+300/(1+0.15)^2+500/(1+0.15)^3+700/(1+0.15)^4 - 1025 = 17.78

0 = 100/(1+0.16)^1+300/(1+0.16)^2+500/(1+0.16)^3+700/(1+0.16)^4 - 1025 = -8.91

For Project L, the IRR is 15%

Since Project S has Higher IRR , Project S should be acepted.

No value will be foregone if Project S is chosen between the two projects because both are mutually exclusive projects and one out of two has to be chosen.

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