Compare The Results Of The Three Methods By Quality 285666

Compare The Results of the Three (3) Methods by Quality of Information for Decision Making

Complete the following homework scenario: 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.

Review the scenario: Assume 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.

Investment and sales prices:

  • Gas Station A: Investment = $50,000; Sale Price = $50,000; CF1 = $0; CF2 = $100,000
  • Gas Station B: Investment = $50,000; Sale Price = $50,000; CF1 = $50,000; CF2 = $25,000

The three capital budgeting methods considered are:

  1. Payback Period: Gas Station A is paid back in 2 years; Gas Station B is paid back in 1 year. The shortest payback period is preferred.
  2. Net Present Value (NPV): Using a 10% discount rate, NPV of Gas Station A is $32,644, and Gas Station B is $16,045. The higher NPV indicates a better investment.
  3. Internal Rate of Return (IRR): Gas Station A has an IRR of approximately 41.42%; Gas Station B has an IRR of approximately 36.60%. The higher IRR indicates a more profitable investment.

Based on the above methods, Gas Station B is favored by payback period, but Gas Station A is favored by NPV and IRR. Your task is to select the best project considering the long-term increase in value and explain your decision, including the understanding of the Time Value of Money principles used or not used in the methods.

Paper For Above instruction

In making investment decisions, capital budgeting methods are essential tools for assessing the potential profitability and value creation of projects. Among these, the Payback Period, Net Present Value (NPV), and Internal Rate of Return (IRR) are widely used. Each method offers different insights and has varying implications for long-term value creation, especially considering the principles of the Time Value of Money (TVM). Evaluating these methods in the context of the scenario involving two gas stations helps in understanding their strengths and limitations in decision-making.

Analysis of the Methods and Their Application to the Scenario

The Payback Period method calculates the time required to recover the initial investment through cash inflows. It is a straightforward and easy-to-understand metric. In the scenario, Gas Station B recovers its investment in one year, while Gas Station A does so in two years. This method favors projects with quicker returns, emphasizing liquidity and risk reduction. However, it ignores cash flows beyond the payback period and does not consider the value of future cash flows, thus neglecting TVM principles.

On the other hand, the Net Present Value method accounts for TVM by discounting future cash flows to their present value. Using a 10% discount rate, the NPV for Gas Station A is significantly higher than that for Gas Station B ($32,644 vs. $16,045). This indicates that Gas Station A adds more value to the firm when considering the time value of money, future cash flows, and risk adjustments. NPV thus aligns with the goal of maximizing shareholder wealth and long-term value.

The IRR method measures the discount rate at which the project's NPV becomes zero. Gas Station A’s IRR is approximately 41.42%, higher than Gas Station B's 36.60%. IRR reflects the project’s profitability relative to the cost of capital and incorporates TVM principles by finding the discount rate that equates cash inflows and outflows. Projects with IRR above the required rate of return are considered acceptable, with higher IRRs indicating better profitability.

Comparison and Decision-Making Implications

Although the payback period method suggests Gas Station B as the better project due to its quicker investment recovery, this method overlooks the magnitude of future benefits beyond the payback horizon and does not apply TVM. The NPV and IRR methods, which do incorporate TVM, favor Gas Station A because of its higher overall value contribution and superior profitability relative to the cost of capital.

Alignment with long-term value creation suggests that NPV is the most comprehensive method, as it directly measures the increase in shareholder wealth. IRR also supports this, indicating higher returns. The payback method, useful for assessing liquidity and risk aversion, is secondary and limited for long-term assessments. Given the emphasis on increasing long-term firm value, the decision should favor Gas Station A based on NPV and IRR results.

The Significance of Time Value of Money in Capital Budgeting

TVM principles hold that money available now is more valuable than the same amount in the future due to its earning potential. The NPV and IRR methods explicitly incorporate TVM by discounting future cash flows, making them superior for evaluating long-term investments. The payback period disregards TVM, making it less suitable for strategic decisions aimed at maximizing long-term value. The scenario elucidates how TVM considerations influence project valuation, reinforcing the preference for methods that recognize the time-based nature of cash flows.

Conclusion

In conclusion, selecting the best project for long-term value creation involves more than just quick cash recovery; it requires comprehensive evaluation considering the Time Value of Money. The NPV and IRR methods, which incorporate TVM, favor Gas Station A, indicating higher potential for increasing shareholder wealth. Conversely, the payback period’s emphasis on short-term liquidity favors Gas Station B but neglects important future benefits. Therefore, when making strategic investment decisions, reliance on NPV and IRR is advisable, aligning with the goal of maximizing long-term value and appropriately applying TVM principles.

References

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  • Investopedia. (2021). Internal Rate of Return (IRR). Retrieved from https://www.investopedia.com/terms/i/irr.asp
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