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Answer on Economics of Enterprise Question for lamarcus streeter

Question #6361

5. 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: 6.00%
Year 0 1 2 3 4

CFS -$1,025 $380 $380 $380 $380

CFL -$2,150 $765 $765 $765 $765

a. $188.68
b. $198.61
c. $209.07
d. $219.52
e. $230.49

Expert's answer

c. $209.07

NPV:
PV[S] = -1025+380•∑(1/1.06^n) ≈ +291.74
PV[L] = -2150+765•∑(1/1.06^n) ≈ +500.8
PV[L] > PV[S]

IRR:
0 = -1025+380•∑(1/(1+IRR)^n) → IRR[S]≈17.861%
0 = -2150+765•∑(1/(1+IRR)^n) → IRR[L]≈15.781%
IRR[L] < IRR[S]
15.781 < 17.861

Since projects are mutually exclusive - then project [L] is preferred (despite lower
IRR - higher investment volume pays out), obviously assuming firm doesn't have any other investment opportunities.

Δ ≈ 500.8 - 291.74 = 209.07

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The assignments were good, however you always forget to add one thing in the assignment and that's is to put the references. Please make sure you update the references in the assignments. Otherwise everything is perfect :) Hope myself and my friend get pass grade.
Saood on July 2013
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