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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: 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.
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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