Compare the results of the three (3) methods by quality of information
for decision making. Using what you have learned about the three (3)
methods, identify the best project by the criteria of long term increase
in value. (You do not need to do further research.) Convey your
understanding of the Time Value of Money principles used or not used in
the three (3) methods. Review the video titled â€œNPV, IRR, MIRR for Mac
and PC Excelâ€ (located at https://www.youtube.com/watch?v=C7CryVgFbBc and previously listed in Week 4) to help you understand the foundational concepts:
Assume that two gas stations are for sale with
the following cash flows; CF1 is the Cash Flow in the first year, and
CF2 is the Cash Flow in the second year. This is the time line and data
used in calculating the Payback Period, Net Present Value, and Internal
Rate of Return. The calculations are done for you. Your task is to
select the best project and explain your decision. The methods are
presented and the decision each indicates is given below.
|Gas Station A||$50,000||$0||$100,000|
|Gas Station B||$50,000||$50,000||$25,000|
Three (3) Capital Budgeting Methods are presented:
- Payback Period: Gas Station A is paid back in 2 years; CF1 in year 1, and CF2 in year 2. Gas Station B is paid back in one (1) year. According to the payback period, when given the choice between two mutually exclusive projects, the investment paid back in the shortest time is selected.
- Net Present Value: Consider the gas station example above under the NPV method, and a discount rate of 10%:
NPVgas station A = $100,000/(1+.10)2 – $50,000 = $32,644
NPVgas station B = $50,000/(1+.10) + $25,000/(1+.10)2 – $50,000 = $16,115
- Internal Rate of Return: Assuming 10% is the cost of funds; the IRR for Station A is 41.421%.; for Station B, 36.602.
Summary of the Three (3) Methods:
- Gas Station B should be selected, as the investment is returned in 1 period rather than 2 periods required for Gas Station A.
- Under the NPV criteria, however, the decision favors gas station A, as it has the higher net present value. NPV is a measure of the value of the investment.
- The IRR method favors Gas Station A. as it has a higher return, exceeding the cost of funds (10%) by the highest return.