Principle Of Finance

 
There are three (3)  types of textbook based homework items located at the end of each  chapter. These include Review Questions (RQ), Exercises (E), and  Problems (P). Some homework items have been custom created.
Complete the following homework scenario:

Required:

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:
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, 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.

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.

superadmin (28431)
New York University
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