Pay Back Period
In the capital budgeting, the payback period is used in the selection criteria of the capital budget. Most of the small business owners find the payback period useful in assessing the period that the business will take to cover the initial capital investment. When making capital budgeting decision, the project selected has less payback period compared to other projects. In this case, the Gas Station B will be selected. The selected project it takes only one year to pay back the initial capital invested ($50,000). However, the method has a lot of deficiencies when the information about the two projects is analyzed. For instance, the method cannot determine the economic live for both Gas Stations.
Net Present Value
NPV is considered to be the most suitable method of making a decision in the capital budgeting. In this sense, an investor will use NPV to make a decision whether to invest or not to invest in a given capital project. In the financial point of view, the method takes the time value of money which is not the case in the payback period method. It discounts the cash flows of each Gas Station for the two years. The investor will always choose the project which produces the highest positive NPV. In this case, Gas Station A is the feasible project to invest as it produces the positive NPV of $32,644.
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Internal Rate of Return
Most of the investors prefer when the performance of a firm is expressed regarding percentage rather than dollars. For instance, an investor will like the IRR compared to the NPV. Thus, IRR is the discounted rate of return of the business or the company’s cost of capital. Similarly, it is the rate that equates the NPV of the project into zero dollars. Similarly, for the project to be acceptable, the IRR should be higher than the cost of capital. Gas Station A is more feasible with IRR of 41.421% higher than Gas Station B.
