A company is considering Projects 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 rather than the one with the higher NPV, how much value will be forgone? RRR: 9.00% CFs CFL -$1,100 -$2,200 $375 $725 $375 $725 $375 $725 $375 $725
Solution
Project S
Net present value is calculated using a financial calculator by inputting the below:
Press the CF button.
CF0= -$1,100. It is entered with a negative sign since it is a cash outflow.
Cash flow for each year should be entered.
Press Enter and down arrow after inputting each cash flow.
After entering the third cash flow cash flow, press the NPV button and enter the required rate of return of 9%.
Press enter after that. Press the down arrow and CPT buttons to get the net present value.
The net present value of cash flows is $114.90. 13.67%
Project L
Net present value is calculated using a financial calculator by inputting the below:
Press the CF button.
CF0= -$2,200. It is entered with a negative sign since it is a cash outflow.
Cash flow for each year should be entered.
Press Enter and down arrow after inputting each cash flow.
After entering the third cash flow cash flow, press the NPV button and enter the required rate of return of 9%.
Press enter after that. Press the down arrow and CPT buttons to get the net present value.
The net present value of cash flows is $148.80. 12.04%
The project chosen based on the internal rate of return is project S since it has the highest internal rate of return.
Value forgone= NPV of project L - NPV of project S
= $148.80 - $114.90
= $39.90.