Complete The Following Homework Scenario Required To Compare

Complete The Following Homework Scenario required compare The Results

Compare the results of the three methods by the quality of information for decision making. Using what you have learned about the three methods, identify the best project by the criteria of long-term increase in value. Convey your understanding of the Time Value of Money principles used or not used in the three methods. Review the video titled "NPV, IRR, MIRR for Mac and PC Excel" 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 provided. Your task is to select the best project and explain your decision. The methods are presented and the decision each indicates is given below.

Comparison of Capital Budgeting Methods

Two gas stations are for sale, with specified cash flows over two years. Gas Station A requires an initial investment of $50,000, has no cash flow in the first year, but yields $100,000 in the second year. Gas Station B also requires $50,000 initially, generates $50,000 in the first year, and $25,000 in the second year.

Using the Payback Period method, Gas Station A is paid back in 2 years, whereas Gas Station B is paid back in 1 year. According to this method, the project with the shortest payback period is preferred, which is Gas Station B in this case.

When calculating Net Present Value (NPV) at a discount rate of 10%, Gas Station A’s NPV is approximately $32,644, indicating higher value creation. Gas Station B’s NPV is approximately $16,115. The NPV method favors Gas Station A for its higher contribution to long-term value.

Regarding the Internal Rate of Return (IRR), Gas Station A’s IRR is about 41.42%, and Gas Station B’s is approximately 36.60%. Both exceed the 10% cost of funds, but Gas Station A offers a higher IRR, suggesting a better return.

Analysis of Decision Criteria and the Time Value of Money Principles

Each method directly or indirectly considers the Time Value of Money (TVM) principles. The NPV and IRR methods explicitly incorporate TVM by discounting future cash flows at a specified rate, recognizing that a dollar today is worth more than a dollar in the future. The payback period method, however, does not account for the TVM principle; it solely measures the time needed for cash inflows to recover the initial investment.

The payback period’s simplicity makes it useful for assessing liquidity risk but flawed in evaluating the project's overall profitability or value contribution over the long term because it ignores cash flows beyond the payback point and does not discount future cash flows. Conversely, NPV and IRR provide a comprehensive view by considering the time-adjusted value of future cash flows, aligning with fundamental TVM principles.

Choosing the Best Project Based on Long-Term Value

Considering the criteria of long-term increase in value, the NPV method provides the most reliable decision-making metric because it quantifies the actual increase in value created by the project. Despite Gas Station B’s shorter payback period, the NPV results favor Gas Station A because it contributes more to shareholder wealth. Similarly, the IRR supports Gas Station A, as it exceeds the discount rate by a higher margin, indicating superior profitability.

Therefore, based on the comprehensive view that considers TVM principles, the long-term value increase, and profitability, Gas Station A is the preferable investment. Although it takes longer to recoup the initial investment, it yields a higher net present value and IRR, indicating a more valuable and profitable project over time.

Conclusion

In conclusion, analyzing these three methods highlights the importance of considering long-term value and the role of TVM in capital budgeting decisions. While payback period offers quick insight into liquidity and risk, NPV and IRR provide more accurate measures of overall profitability and value creation. Stakeholders should prioritize methods that incorporate TVM principles, like NPV and IRR, for investment decisions aimed at maximizing long-term wealth. In this case, Gas Station A emerges as the best project, aligning with the goal of long-term value enhancement.

References

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• Investopedia. (2023). Internal Rate of Return (IRR). https://www.investopedia.com/terms/i/irr.asp
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