Week 10 Assignment 10: Homework 10
FIN 100: Principles Of Finance
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. 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:
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.
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:
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%:
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.
It may not make sense to some who want the money as soon as possible but Gas Station A should be selected, even though the investment was returned in 2 periods versus the 1 period for Gas Station B. Both the IRR method and the NPV criteria favor gas station A because it has more value that as an investment even though it took longer for it to pay itself off. If someone is looking to just have it paid off as quickly as possible and try to get “immediate” returns than gas station B would be the way to go but looking more long term gas station A seems as though it has better prospects.