Capital budgeting allows a company to determine the feasibility of a proposed project by analyzing its returns over a given period. There are several techniques on capital budgeting including net present value (NPV), accounting rate of return (ARR), payback period, and internal rate of return (IRR). Each of these techniques evaluates the project returns and determine its feasibility based on different decision rules.
Result Comparison
Payback period method evaluates the expected timeframe for the company to enjoy returns from the investment. For mutually exclusive projects, the project that offers returns in the shortest period is the most viable. In the case provided, investment in Gas A will pay back in two years while that of Gas B will take a year. The decision is to invest in Gas B, not Gas A. However, this method is not the most appropriate as it does not take into account the time value for money.
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Net present value shows the difference between the present values of the cash flows from the investment. Gas station A has an NPV of $32,644 while that of Gas station B is $16,115. In this case, Gas station A has the highest NPV hence it is more viable. The IRR for Gas station A is 41.42% while that of B is 36.6%. Both stations have an IRR that exceeds the expected rate of return of 10%. However, A is more viable as it has a higher IRR.
Decision
In the analysis, payback period method favors investment in gas station B while NPV and IRR favor gas station A. The decision is to invest in gas station A because the NPV and IRR are more reliable techniques because they take into account the time value of money. Both techniques discount the present value of cash flow to take into account the future earning of cash. Therefore, project A is likely to have long-term value for the company.
