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. Investment Sales Price CF1 CF2 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.

Explanation / Answer

Payback Period Method Payback period means the period during which the amount of initial investment is recovered fully. Usually the formula which can be used is = Initial Investment Annual cash flows Decision making : Project which has lower payback period is accepted among more than one projects. In this case For Gas station A Payback period is 2 years whereas for Gas station B it is 1 year, hence project B should be selected. Net Present Value (NPV) NPV = Present value of cash inflows less Present value of cash outflows Decision Making : Between the 2 options Project with highest NPV is to be selected. In this case NPV for Gas station A is $32,644 and For Gas station B is $16,115, hence Project A is to be selected as it has higher NPV IRR IRR is the actual rate of return which a project is generating. At IRR Present value of cash inflows & Present value of cash outflows are equal. Decesion Making In case of more than one project, Project having Higher IRR will be selected subject to IRR should be more than cost of funds of the company in this case IRR for Gas station A is 41.421% and for Gas station B is 36.602%, so Project A Should be selected as it has higher IRR and which is also more than Cost of funds of the company which is 10%

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