Managerial Accounting Harbisson-Drake Is Faced Research Proposal

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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

PV

$ (400,000)

$71,429

$75,733

$85,414

$76,262

$62,417

Project NPV

$ (28,745)

The net present value for the second option is -$28.745.

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This is also a negative NPV, meaning that the cost savings from this option do not pay for the initial cost of the project. The second option has greater cost savings, but these are offset by a couple of factors. The first is that the initial cost is higher. The second is that the highest dollar savings are in years 3-5. Once the time value of money is taken into account, these are subject to high discount rates that diminish those dollar values significantly. The result is that in total, the second option is actually worse than the first option.

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….....

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