FIN 100 Homework 2

Homework 2

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.) Convey your understanding of the Time Value of Money principles used or not used in the three (3) methods.

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 time line 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.

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%:
NPVgas station A = $100,000/(1+.10)2 – $50,000 = $32,644
NPVgas 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:

The obvious numbers are presented for gas stations A and B, with both producing a return of investment; however they differ largely in amounts and amount of time for return. The NPV and IRR are the methods most likely to be used simply because they do consider the time value of money. Investments should be considered, as in this case, for their long-term profitability. While it is preferable to see an immediate return, there are generally greater benefits with longer term investments, thus the added time increases the actual value of the investment. The Payback Period does not consider the time value of money, but only seeks the fastest rate of return. In this case, gas station B would be the most appealing, because the investment is returned in a shorter time frame. The drawback, however, is that the potential gains of twice the investment are lost because there is less time, thus less value. Both gas stations are independent of one another; therefore, the NPV and IRR should be used based on the merits that they include more variables and thus have the potential to make more insightful decisions on long-term profitability and gain. Both NPV and IRR attribute greater values to Gas Station A; therefore being the majority “vote” for best choice of investment. While Gas Station A may seem like a riskier choice, for the length of time for return, greater risks are condoned with increased likelihood of greater returns and NPV and IRR present valid arguments for the return of investments with Gas Station A.