Time Value of Money

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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 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. 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 $100,000
Gas Station B $50,000 $50,000 $25,000

Three (3) Capital Budgeting Methods

are presented:

  1. 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.
  2. 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
  3. 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.
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