Thus, cash savings of equal dollar amounts will have a higher present value in year one and a lower present value in year five.
For the first option, the net present value calculation is as follows:
Option 1
Year
0
1
2
3
4
5
Cost
$ (350,000)
Savings
$92,000
$92,000
$92,000
$92,000
$92,000
PV
$ (350,000)
$82,143
$73,342
$65,484
$58,468
$52,203
Project NPV
$ (18,361)
This calculation therefore indicates that the net present value of option 1 is -$18,361. That is, the option does not have a negative net present value. A basic rule of thumb is that firms should not undertake activities that do not have a positive net present value. The cost savings of option 1 do not, when the time value of money is taken into consideration, pay for the project.
For the second option, the present value calculation is as follows:
Option 2
Year
0
1
2
3
4
5
Cost
$ (400,000)
Savings
$80,000
$95,000
$120,000
$120,000
$110,000
However, it is worth nothing that both options have a negative net present value. Therefore, Harbisson-Drake should pursue neither option. At the company's current cost of capital, it will lose money on a present value basis if it pursues either of these options. Indeed, a sensitivity analysis shows that even if the company assumes it will finance these options through its lowest cost source of capital, debt, both projects will still have a negative NPV using a discount rate of 10%. Naturally, it is better to adopt a more conservative approach and use the 12%, but in either case the result is the same. The company should not pursue either of these options.
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