A company is analyzing two mutually exclusive projects, S and L, with the follow

Question

A company is analyzing two mutually exclusive projects, S and L, with the following cash flows: .............................. 0....................1...................2................3..................4 Project S............-$1,000...........$886.38..........$250.........$15...............$10 Project L............-$1,000............$10.................$250.........$400............$821.16 The company's WACC is 8.5%. What is the IRR of the better project? (Hint: The better project may or may not be the one with the higher IRR). Round the answer to two decimal places. SHOW YOUR WORK!

Explanation / Answer

when the NPV=0, the discounted rate is the IRR. that is, NPV(project S)=0=-1000+900/(1+IRR)+250/[(1+IRR)^2]+1… therefore, the IRR for project S=13.49%, by using the same way for the project L. 0=-1000+0+250/[(1+IRR)^2]+400/[(1+IRR)… IRR(project L)=11.74% IRR(porject S)=13.49%>IRR(project L)=11.74%, but you can not make the decision right away. you need to take a look of their NPV by using the WACC. because the selection based on IRR sometimes might have some conflicts with the choice made by looking at the NPV. NPV(projectS)=-1000+900/(1+10%)+250/[(… therefore the NPV=39.14 by using the same method, we get NPV(project L)=-1000+0+250/[(1+10%)^2]+400/[(1+10%)^… so, now we get 0WACC=10% choose Project S when meeting the conflicts for these two methods, we always follow the NPV other than IRR method, therefore, we should choose porject L. its the rule. this is due to the drawbacks of IRR methods.

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