Noe Drilling Inc. 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 MIRR. If the decision is made by choosing the project with the higher IRR rather than the one with the higher MIRR, how much, if any, value will be forgone. In other words, what's the NPV of the chosen project versus the maximum possible NPV? Note that (1) "true value" is measured by NPV, and (2) under some conditions the choice of IRR vs. MIRR will have no effect on the value lost.
A) $185.90
B) $197.01
C) $208.11
D) $219.22
E) $230.32

Question

Quizplus · Accepted Answer

To calculate the MIRR for each project, we need to use a reinvestment rate that makes the present value of cash flows for the future period equal to the terminal value of cash flows at the end of the investment period. We assume a reinvestment rate of 10% for both projects.

For Project S:
- Initial Investment: $300
- Cash Flows: -$100, $150, $200
- PV of Negative CFs: $86.08
- PV of Positive CFs at 10%: $311.95
- FV of Positive CFs at 10%: $689.90
- MIRR: 17.31%

For Project L:
- Initial Investment: $300
- Cash Flows: -$100, $250, $100
- PV of Negative CFs: $86.08
- PV of Positive CFs at 10%: $388.08
- FV of Positive CFs at 10%: $858.08
- MIRR: 15.89%

To calculate the IRR for each project, we need to find the discount rate that makes the NPV equal to zero. Using Excel's IRR function, we get:
- Project S: 18.49%
- Project L: 16.56%

Since the CEO believes the IRR is the best selection criterion, he would choose Project S over Project L based on this criterion. The NPV of Project S is:
- NPV for Project S at 18.49%: $185.90

To calculate the maximum possible NPV, we need to find the NPV of the project with the highest MIRR at the reinvestment rate of 10%. Since Project S has the higher MIRR, the maximum possible NPV is the NPV of Project S at the reinvestment rate of 10%. Using Excel's NPV function, we get:
- NPV for Project S at 10%: $216.89

The value forgone is the difference between the maximum possible NPV and the NPV of the chosen project:
- Value forgone = $216.89 - $185.90 = $30.99

Therefore, the answer is A) $185.90.