Managerial Accounting Harbisson-Drake Is Faced

Managerial Accounting

Harbisson-Drake is faced with the decision between a couple of options for improving profitability. The company can build a new plant that will operate more efficiently than the present facilities (Option 1) or it can upgrade the existing plant in order that it may operate more efficiently (Option 2). This paper will walk through the process of determining the net present value of each option and will conclude with a recommendation as to the best course of action for Harbisson-Drake.

The first step to determining which option, if any, is better for Harbisson-Drake Manufacturing Company is to determine the weighted average cost of capital. This will be used as the discount rate in order to account for the time value of the future cash flows. The weighted average cost of capital reflects the company's estimate of the cost for the company to acquire new funding. In this instance, the company has determined that the cost of debt is 10%; the cost of preferred shares is 16%; and the cost of common shares is 13.5%. In order to determine the weighted average cost of capital, these costs must then be weighted against the company's existing capital structure. The current capital structure for Harbisson-Drake is 50% debt, 10% preferred shares and 40% common shares. Thus, the calculation of the weighted average cost of capital will be as follows:

Amount

% of Total

CoC

Weight

Debt

1,000,000

0.5

10%

5.00%

Preferred

200,000

0.1

16%

1.60%

Common

800,000

0.4

13.50%

5.40%

2,000,000

12.00%

WACC

The weighted average cost of capital for Harbisson-Drake is therefore 12%. This reflects the discount rate, or the firm's normal risk in new ventures that it undertakes. There is some indication that management intends to pursue debt for its new venture, but for now we shall consider 12% as the appropriate discount rate that will preserve the firm's current capital structure.

The second step is to calculate the net present value of each option available to the company. The net present value of each option will consist of the immediate cash outlay (Year 0) and then the annual cost savings that are expected for the future (Years 1-5). The basic present value calculation is as follows:

PV = Amount / (1 + discount rate) ^ Year

This reflects the fact that the time value of money diminishes the value of future cash flows by greater amounts with each passing year. 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. 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.