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: CFs CFL 1 2 3 4 10.75% 0 -$1,350 -$2,700 $950 $950 $950 $950 $490 $490 $490 $490 a. $239.01 b. $0.00 O c. $76.55 Od. $84.78 Oe. $325.70

Essentials Of Investments
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Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
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### Evaluating Projects S and L: Cash Flow Analysis

**Context:**
A firm is considering two mutually exclusive projects, Project S and Project L. The projects have been evaluated based on their expected cash flows, which are outlined below. Both projects exhibit equal risk profiles and are non-repeatable. The assessment includes differing opinions on the best decision criterion: the CEO prefers the Internal Rate of Return (IRR) criterion, whereas the CFO advocates for the Net Present Value (NPV) method. The following analysis aims to identify the best procedural decision and quantify the potential loss in firm value if the suboptimal criterion is chosen.

**Project Cash Flows:**

Project S:
- Year 0: -$1,350
- Year 1: $490
- Year 2: $490
- Year 3: $490
- Year 4: $490

Project L:
- Year 0: -$2,700
- Year 1: $950
- Year 2: $950
- Year 3: $950
- Year 4: $950

**Weighted Average Cost of Capital (WACC):** 10.75%

#### Key Cash Flow Information:
| Year | Cash Flow S (CFs) | Cash Flow L (CFl) |
|------|-------------------|-------------------|
| 0    | -$1,350           | -$2,700           |
| 1    | $490              | $950              |
| 2    | $490              | $950              |
| 3    | $490              | $950              |
| 4    | $490              | $950              |

**Question:**
How much potential value would the firm lose if the wrong decision criterion is used?

**Options:**
a. $239.01  
b. $0.00  
c. $76.55  
d. $84.78  
e. $325.70

#### Detailed Explanation:

To determine the potential loss, we must first calculate the Net Present Value (NPV) and Internal Rate of Return (IRR) for both projects and compare the results to determine which provides the higher value.

**Graphical and Diagram Explanation:**
The table summarizes the annual cash flows for both projects. The year-by-year cash inflows are listed alongside the initial outflows (investments) in Year 0. The firm must compare the IRR
Transcribed Image Text:### Evaluating Projects S and L: Cash Flow Analysis **Context:** A firm is considering two mutually exclusive projects, Project S and Project L. The projects have been evaluated based on their expected cash flows, which are outlined below. Both projects exhibit equal risk profiles and are non-repeatable. The assessment includes differing opinions on the best decision criterion: the CEO prefers the Internal Rate of Return (IRR) criterion, whereas the CFO advocates for the Net Present Value (NPV) method. The following analysis aims to identify the best procedural decision and quantify the potential loss in firm value if the suboptimal criterion is chosen. **Project Cash Flows:** Project S: - Year 0: -$1,350 - Year 1: $490 - Year 2: $490 - Year 3: $490 - Year 4: $490 Project L: - Year 0: -$2,700 - Year 1: $950 - Year 2: $950 - Year 3: $950 - Year 4: $950 **Weighted Average Cost of Capital (WACC):** 10.75% #### Key Cash Flow Information: | Year | Cash Flow S (CFs) | Cash Flow L (CFl) | |------|-------------------|-------------------| | 0 | -$1,350 | -$2,700 | | 1 | $490 | $950 | | 2 | $490 | $950 | | 3 | $490 | $950 | | 4 | $490 | $950 | **Question:** How much potential value would the firm lose if the wrong decision criterion is used? **Options:** a. $239.01 b. $0.00 c. $76.55 d. $84.78 e. $325.70 #### Detailed Explanation: To determine the potential loss, we must first calculate the Net Present Value (NPV) and Internal Rate of Return (IRR) for both projects and compare the results to determine which provides the higher value. **Graphical and Diagram Explanation:** The table summarizes the annual cash flows for both projects. The year-by-year cash inflows are listed alongside the initial outflows (investments) in Year 0. The firm must compare the IRR
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