Tesar Chemicals is considering Projects S and L, whose cash flows are shown belo

Question

Tesar Chemicals 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 NPV. If the decision is made by choosing the project with the higher IRR rather than the one with the higher NPV, how much, if any, value will be forgone, i.e., what's the chosen NPV versus the maximum possible NPV? Note that (1) "true value" is measured by NPV, and (2) under some conditions the choice of IRR vs. NPV will have no effect on the value gained or lost.



WACC: 7.50%

Year 0 1 2 3 4

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

CFL -$2,700 $650 $725 $800 $1,400

Explanation / Answer

First, recognize that NPV makes theoretically correct capital budgeting decisions, so the highest NPV tells us how much value could be added. We calculate the two projects' NPVs, IRRs, and MIRRs, but the MIRR information is not needed for this problem. We then see what NPV would result if the decision were based on the IRR (and the MIRR). The difference between the NPV is the loss incurred if the IRR criterion is used. Of course, it's possible that IRR could choose the correct project. WACC: 7.5000% Year 0 1 2 3 4 TV MIRR CFS -$1,100 $550 $600 $100 $100 Compounded CFs: 673.77 686.94 107.00 100.00 $1,567.71 9.5469% CFL -$2,700 $650 $725 $800 $1,400 Compounded CFs: 796.28 830.05 856.00 1400.00 $3,882.33 9.6663% MIRR, L = 9.67% IRR, L = 10.71181% NPV, L = $224.3065 MIRR, S = 9.55% IRR, S = 12.24157% NPV, S = $86.2036 MIRR Choice: L IRR Choice: S NPV Choice: L NPV using MIRR: $224.31 NPV using IRR: $86.20 NPV using NPV: $224.31 Lost value using IRR versus MIRR: $138.10 Loss below: 7.9850% Lost value using MIRR versus NPV: $0.00 Loss below: 10.1638% Lost value using IRR versus NPV: $138.10 Loss below: 10.1638%

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