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The answer may appear obvious since the savings ($82,500 = 5 years x $16,500) exceeds investment ($50,000). However, it is not enough that the cost reductions cover the investment. It must also yield a return of at least 20%.
To determine the suitability of the investment, the £16,500 annual savings should be discounted to its present value. Since the company uses a 20% minimum hurdle, this rate is used in the discounting process and is called the discount rate. See Table 5.5. Deducting the present value of the required investment from the present value of the cost savings gives the net present value of -f648. According to the analysis, the company should not proceed. |