Your company is choosing between following non-repeatable, equally risky, mutually exclusive projects with the cash flows shown below.Your required rate of return is 10 percent.How much value will your firm sacrifice if it selects the project with the higher IRR?

Question

Quizplus · Accepted Answer

The project with the higher IRR is Project B, which has an IRR of 15%. However, the required rate of return is only 10%, which means that Project B is overestimating its potential return. To determine the value sacrificed by selecting the higher IRR project, we need to calculate the net present value (NPV) of each project using the required rate of return of 10%.

Project A: 
NPV = -$1,000 + ($300 / 1.1) + ($400 / 1.1^2) + ($500 / 1.1^3) = -$1,000 + $272.73 + $330.58 + $378.23 = $-18.46

Project B:
NPV = -$2,000 + ($600 / 1.1) + ($800 / 1.1^2) + ($1,000 / 1.1^3) = -$2,000 + $545.45 + $661.16 + $756.15 = $-37.24

Therefore, Project A has a higher NPV and should be chosen. The value sacrificed by selecting Project B is the difference in NPVs, which is $18.46 - (-$37.24) = $55.70. However, this value sacrifice would only apply if the company made the mistake of choosing Project B over A, which we've already determined should not be done.

Your Company Is Choosing Between Following Non-Repeatable, Equally Risky, Mutually