Question

Required:

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 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:

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%:
   • 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
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.

Answer 1

	Gas station A	Gas station B
Payback period in Years	2	1	According to Payback period Project B Payback period is less than Project A and both the projects are mutually exclusive so project B should be selected on the basis of payback period.
NPV in dollars	32644	16115	According to NPV both the project can be selected as NPV of both the projects are positive but as projects are mutually exclusive so one project would be choosen so in this case project A would be choosen over project B as NPV is greater than project B NPV
IRR in %	41.42%	36.60%	According to IRR both the project can be selected as IRR of both the projects are greater than required rate of return of 10% but as projects are mutually exclusive so one project would be choosen so in this case project A would be choosen over project B as IRR is greater than project B IRR
On the basis of methods used, Payback period method only focus on time period to recover the initial investment so due to its limitation of ignorance of concept of time value of money and ignorance of cash flow after the recovery of initial investment, makes it a not very effective technique of capital budgeting
NPV method consider time value of money and reveals the benefits in present terms but rate at which cash flows are discounted, accuracy in the determination of discount rate is very crucial and success of NPV method depends on the accuracy of discount rate
IRR is having a drawback of reinvestment of cash flow at a rate equal to IRR which in actual not possible so interim cash flow can be invested at different rate.
so on the basis of the drawbacks of the method, NPV seems to be a better method due to its assumptions and technique used to calculate the net benefits from Investment