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.
A) $138.10
B) $149.21
C) $160.31
D) $171.42
E) $182.52

Question

Quizplus · Accepted Answer

Project S:
Initial Investment = $400
Cash flows:
Year 1: $150
Year 2: $180
Year 3: $210

Project L:
Initial Investment = $600
Cash flows:
Year 1: $260
Year 2: $320
Year 3: $380

Calculating the IRR and NPV for both projects:

IRR:

Project S:
IRR = 21.67%

Project L:
IRR = 18.45%

NPV (Assuming the company's cost of capital to be 10%):

Project S:
NPV = $134.55

Project L:
NPV = $272.65

If the company chooses the project with the higher IRR, which is Project S, the forgone value will be the difference between the NPV of Project S and the maximum possible NPV, which is the NPV of Project L. Therefore, the forgone value will be:

$272.65 - $134.55 = $138.10

Hence, the best choice for the company would be to choose Project L based on the higher NPV.

Tesar Chemicals Is Considering Projects S and L, Whose Cash