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?

WACC:	6.75%
	0	1	2	3	4
CFS	-$1,025	$380	$380	$380	$380
CFL	-$2,150	$765	$765	$765	$765

Answer 1

=NPV(rate, Year1 to Year4 cashflows)-Year0 cashflow

=IRR(values)=IRR(Year0 to Year4 cashflows)

WACC 6.75% Period Project S Project L -1025 -2150 380 765 380 765 380 765 380 765 NPV 269.44 455.91 IRR 5.56% 15.78%

In general, NPV is the better approach if we have any conflict between IRR and NPV because NPV tells by how much shareholders wealth increases. IRR's drawback is that it will have multiple IRRs for the same project if the future expectations changes.

But in the above case, both NPV and IRR is high for Project L. Hence they should accept project L. The maximum loss they incur if they approve wrong project is $455.91-$269.44=$186.47