Capital Budgeting

Gas Station A should be selected. Under the Net Present Value (NPV) method the firm should consider gas station A since its NPV of $32,644 is positive and exceeds cash outflows. The NPV value of Gas station A is higher as compared to $16,115 of Gas station B. Based on the Internal Rate of Return (IRR) rule; the organization accepts the project having an IRR which is higher than the cost of finance. In this case, the firm should accept Gas station B which its IRR equals to 41.421%. The internal return rate of Gas station B is lower than that of Gas station A and hence cannot be selected. Based on payback method, Gas station B has the shortest payback period of one year as compared to two years of Gas station A. According to the payback period, Gas station B should be selected. However, the payback period method does not consider the time value of money and also does not take into account extra income beyond the calculated PBP and hence the selection of the projects cannot be based on this method.

In gauging the profitability of an investment, NPV method considers the entire inflows to be produced by the venture and thus it indicates whether the investment will create value for the organization. Time value of money is considered in this model and hence compares dollar at its current value. Also, NPV method considers the cost of capital and inherent risks for future projection. This method is compatible with maximization of owners’ wealth since an IRR which is higher than the cost of capital reflects higher returns. The interpretation of IRR results is straightforward to interpret after calculation and managers can visualize and select the best ventures easily. Additionally, this model considers takes into consideration the entire returns of the investment (Juhász, 2011, p. 50).

References

Juhász, L. (2011). Net present value versus internal rate of return. Economics & Sociology, 4(1), 46-53.