Kosovski Company is considering Projects S and L whose cash

Kosovski Company is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and are not repeatable. If the decision is made by choosing the project with the higher IRR, how much value will be forgone? Note that under some conditions choosing projects on the basis of the IRR will cause $0.00 value to be lost. WACC: 7.75% Year 0 1 2 3 4 CFS ?$1,050 $675 $650 CFL ?$1,050 $360 $360 $360 $360

a. $19.35

b. $11.45

c. $14.63

d. $12.72

e. $16.82

Solution

Let irr be x%
At irr,present value of inflows=present value of outflows.

S:

1050=675/1.0x+650/1.0x^2

Hence x=irr=17.14%(Approx).

L:

1050=360/1.0x+360/1.0x^2+360/1.0x^3+360/1.0x^4

Hence x=irr=13.95%(Approx).

Hence as per IRR rule;project S must be chosen having higher irr.

As per NPV at 7.75%:

Present value of inflows=cash inflow*Present value of discounting factor(rate%,time period)

S:

Present value of inflows=675/1.0775+650/1.0775^2

=$1186.31(Approx)

NPV=Present value of inflows-Present value of outflows

=(1186.31-1050)

=$136.31(Approx)

L:

Present value of inflows=360/1.0775+360/1.0775^2+360/1.0775^3+360/1.0775^4

=$1199.03

NPV =$1199.03-$1050

=$149.03(Approx).

Hence as per NPV;project L must be chosen having higher NPV.

Hence value lost=(149.03-136.31)

=$12.72(Approx).