Question

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 timeline 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%:

NPV _{gas station A} = $100,000/(1+.10)² - $50,000 = $32,644

NPV _{gas 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.

Answer 1

On the basis of three methods (payback period, NPV and IRR) we will select Gas Station A.

As we see in the question that NPV and IRR of Gas Station A is higher in compare to Gas Station B. Thus we should make investment in Gas Station A. Although it is also given that payback period of Gas station A is more than Gas station B that means investment of Gas station A will be recovered in more time in compare to Gas station B, but due to NPV and IRR analysis investment in Gas station A will be profitable because due to higher payback period Gas Station A will generate higher net return in long-term hence investment in Gas station A will be good option.

As we know that while we calculate NPV then we need to calculate return discounted with discounting factor hence decision made on the basis of NPV and IRR will be better option between two mutual project.

Thus as a result, we can say that investment in gas station A will be better option.