Compare the results of the three (3) methods by quality of information for decis

Question

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 “NPV, IRR, MIRR for Mac and PC Excel” (located at https://www.youtube.com/watch?v=C7CryVgFbBc and previously listed in Week 4) to help you understand the foundational concepts:

Scenario Information:
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.

Three (3) Capital Budgeting Methods are presented:

1. 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.

2. 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

3. 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.

Explanation / Answer

NPV is the most suitable criterion when it comes to comparison. As it considers the time value of money in abosulte monetary benefit. Payback period can give absurd results in many cases. As far as IRR is concerned, it considers the cost of funds and compares it with the rate of return generated by the project.

All other things being equal, using internal rate of return (IRR) and net present value (NPV) measurements to evaluate projects often results in the same findings. However, there are a number of projects for which using IRR is not as effective as using NPV to discount cash flows. IRR's major limitation is also its greatest strength: it uses one single discount rate to evaluate every investment.

Although using one discount rate simplifies matters, there are a number of situations that cause problems for IRR. If an analyst is evaluating two projects, both of which share a common discount rate, predictable cash flows, equal risk, and a shorter time horizon, IRR will probably work. The catch is that discount rates usually change substantially over time. For example, think about using the rate of return on a T-bill in the last 20 years as a discount rate. One-year T-bills returned between 1% and 12% in the last 20 years, so clearly the discount rate is changing.

Without modification, IRR does not account for changing discount rates, so it's just not adequate for longer-term projects with discount rates that are expected to vary.

Another type of project for which a basic IRR calculation is ineffective is a project with a mixture of multiple positive and negative cash flows.

Thus, there are at least two solutions for IRR that make the equation equal to zero, so there are multiple rates of return for the project that produce multiple IRRs. The advantage to using the NPV method here is that NPV can handle multiple discount rates without any problems. Each cash flow can be discounted separately from the others.

Another situation that causes problems for users of the IRR method is when the discount rate of a project is not known. In order for the IRR to be considered a valid way to evaluate a project, it must be compared to a discount rate. If the IRR is above the discount rate, the project is feasible; if it is below, the project is considered infeasible. If a discount rate is not known, or cannot be applied to a specific project for whatever reason, the IRR is of limited value. In cases like this, the NPV method is superior. If a project's NPV is above zero, then it is considered to be financially worthwhile.

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