Compare the results of the three methods by 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. (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 methods. Review the video titled "NPV, IRR, MIRR for Mac and PC Excel" (located at 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
Complete the following homework scenario:
Compare the results of the three methods by 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. (You do not need to do further research.) Convey your understanding of the
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,
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Investment
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Sales Price
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CF1
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CF2
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Gas Station A
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$50,000
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$0
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$100,000
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Gas Station B
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$50,000
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$50,000
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$25,000
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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 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 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.
Question: What is a drawback(s) of using the Payback Period Method?
| A. |
The Payback Period Method is simple to understand |
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| B. |
The Payback Period Method ignores the time value of money |
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| C. |
The Payback Period Method ignores all cash flows beyond the payback period |
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| D. |
Both B and C |
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| E. |
None of the above |
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