Ross Inc.\'s CFO thinks the company should rely primarily on the NPV method, but

Question

Ross Inc.'s CFO thinks the company should rely primarily on the NPV method, but the president prefers the IRR, so decisions are based on the IRR. The CFO wants you to show the president that at times decisions based on the IRR result in a reduction in the company's value relative to its value if the NPV criterion were used. The CFO then asked you to analyze two projects that the company is now considering, 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 Ross be foregoing? Be sure to report the IRR and NPV for both projects, using Excel functions, as part of your final answer.

WACC 13%

Year 0 1 2 3 4   

Cash Flow Project S ($3400) 2100 2400

Cash Flow Project L ($4300)1200 1575 1850 1975

Explanation / Answer

Here project S will be taken on basis of higher IRR.

But value lost = 488.85-337.96 = 150.89 (NPV is calculated on WACC basis, any project which provides more return than WACC is attractive for the firm, now if the project L is foregone because of higher IRR, firm looses an opportunity to generate more money albeit it is at a lower IRR but lower IRR > WACC)

0 1 2 3 4 S -3400 2100 2400 L -4300 1200 1575 1850 1975 NPV IRR S 337.96 20% L 488.85 18%

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