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 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.
InvestmentSales PriceCF1CF2Gas Station A$50,000$0$100,000Gas 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.
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.