A firm is considering Projects S and L, whose cash flows are shown below. These
ID: 2776738 • Letter: A
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?
Required return: 6.00%
Year
0
1
2
3
4
Cash flows of Project S
-$1,055
$400
$400
$400
$400
Cash flows of Project L
-$2,050
$700
$700
$700
$700
$44.53
$331.04
$375.57
$5.27
None of the above
Year
0
1
2
3
4
Cash flows of Project S
-$1,055
$400
$400
$400
$400
Cash flows of Project L
-$2,050
$700
$700
$700
$700
Explanation / Answer
For mutually exclusive projects, NPV is the best method to use.
To calculate NPV, we need to discount each cash flow and calculate its present value.
Project S
Year
CF S
PV factor 6%
PV
0
-1055
1.0000
-1055.00
1
400
0.9434
377.36
2
400
0.8900
356.00
3
400
0.8396
335.85
4
400
0.7921
316.84
331.04
NPV = 331.04
Project L
Year
CF L
PV factor 6%
PV
0
-2050
1.0000
-2050.00
1
700
0.9434
660.38
2
700
0.8900
623.00
3
700
0.8396
587.73
4
700
0.7921
554.47
375.57
Value lost will be the difference between the NPVs of these two projects:
Value lost = 375.57-331.04
= 44.53
Hence, option A is correct.
Year
CF S
PV factor 6%
PV
0
-1055
1.0000
-1055.00
1
400
0.9434
377.36
2
400
0.8900
356.00
3
400
0.8396
335.85
4
400
0.7921
316.84
331.04
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