NPV Assessment of National Guard Armory Plan Essay

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Finance

Assessment of National Guard Armory Proposal from a Financial Perspective

The State of Massachusetts would like to replace a National Guard armory, to assess whether or not replacement is a viable strategy it is essential to assess the costs against the alterative of retaining the existing the current armory. There are several different methods of assessment which may be used; one of the most popular is the net present value (NPV) (Boehlje & Ehmke, 2013). This takes the cost of a future project and the gains or costs, and discounts them into today's value. By discounting the savings (or cash flows) on a compound basis the time value of money is incorporated into an assessment, so different projects may be assessed and compared on a like for like basis (Berk, DeMarzo, & Harford, 2011).

The aim of this paper is to compare the potential costs associated with building a new armory, with the costs associated keeping the existing armory. The paper will start by explaining how the net present value may be calculated, using discount factors, and the calculation of those discount factors. The discounted factors will then be used in the calculation of the net present values and an assessment presented. It is assumed that the objective will be based ion the cost of the two options. However, there may also be other considerations, which are also discussed at the end of the paper.

2.

Calculating Net Present Value

The process of calculating the net present value is quite straightforward. The first stage is to determine an appropriate discount rate; this may be the expected inflation rate, it may be the cost of capital to the organization, or it may be an adjusted discount rate to allow for additional risk (Berk et al., 2011). The case gives the discount rate as 4%.

Once the discount rate is calculated the next stage is to calculate the discount factor. Each year will have a different discount factor (Berk et al., 2011). The discount factor is a figure which is multiplied by the current value of saving or cash flow in that year, to give the rate that the same amount in that year will be in today's value. The discount amount is calculated for each year, and then added together.

The equation for calculating the discount rate is

PV = FV / (1+r) n

In this equation PV is the present value, FV is the future value, r is the interest rate or discount, already stated as 4% for this case and n is the number of years from now, which as seen blow will be between 1 and 15. The discount rate will be shown as a decimal figure and not a percentage. The discount rates are shown in table 1 below. Net present value refers to the net benefit, so if there is an initial investment this is deducted from the total (Berk et al., 2011), but in this case the maintenance of the armory does not require any additional investment.

Table 1; Discount rates

Year

Discount rate

1

0.961538

2

0.924556

3

0.888996

4

0.854804

5

0.821927

6

0.790315

7

0.759918

8

0.73069

9

0.702587

10

0.675564

11

0.649581

12

0.624597

13

0.600574

14

0.577475

15

0.555265

With the discount rates it is possible to calculate the net present value of the projects. The first calculation is the assessment of the costs for retaining the current armory. The maintenance costs have been estimated at $275,000 per annum. Table 2 below shows the calculation, each years cost is discounted by the corresponding discount factor, giving the value for the individual years.

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Following this the annual amounts are added together.

Table 2 Net present value calculation

Year

Cost

Discount rate

Discounted cost

1

275,000

0.961538

264,423

2

275,000

0.924556

254,253

3

275,000

0.888996

244,474

4

275,000

0.854804

235,071

5

275,000

0.821927

226,030

6

275,000

0.790315

217,336

7

275,000

0.759918

208,977

8

275,000

0.73069

200,940

9

275,000

0.702587

193,211

10

275,000

0.675564

185,780

11

275,000

0.649581

178,635

12

275,000

0.624597

171,764

13

275,000

0.600574

165,158

14

275,000

0.577475

158,806

15

275,000

0.555265

152,698

Total

3,057,557

Taking all of the costs for the coming 15 years, this indicates the total cost in today's terms of retaining the current armory is $3,057,557.

The alternative was to build a new armory. This would be built today at a cost of $4,000,000. As the cost is made in the current year, this does not need to be subjected to a NPV calculation, as there is only cash flow in this year. However, as a result of the investment there would be the elimination of the maintenance costs calculated in table 2.

Now a comparison can be made, the cost of the new armory against the cost of maintaining the existing armory. If the cost of maintenance is $3,057,577 and the cost of a new armory is $4,000,000, it become apparent that it is more cost effective to maintain the current armory, as it costs an additional $942,443 to build the new armory.

The cost benefit ratio is the benefit divided by the costs, so for the new armory this $3,057,577/$4,000,000 = 0.76. So for every $1 spent in the new armory, there would only be benefit worth $0.76 gained. Overall, in retaining the existing armory there will be a surplus of $942,443 compared to the proposed expenditure.

However, there may also need to be consideration of the costs and the way in which they are categorized. There are two types of cost in accounting; capital costs and operating costs. Operating costs are the costs that are incurred in the normal running or operating of a project. This has been given as $275,000 for the existing armory to be kept and maintained. Capital costs are the costs associated with a new project or investment; they are spent in order to create an asset which has a life of 12 months or more.

The cost of the capital investment is then accounted for using the matching principle; this means that although there is a large initial investment, the cost is accounted for over the life of the asset. In this case, the asset will be written off over the expected 15-year life. There are different method of deprecation of the straight line method is used, this will show as a write down of $266,666 per month. The idea is to spread the cost of the asset cost over its useful life. Notably, this is an amount less that the projected maintenance cost. If the military have limited operating budgets, but have a surplus in the capital budget, this may be used to justify the spend and support the decision for a new armory, However, it is not a saving in real terms, but it may be used as an accounting tool, as it comparing an operating cost incurred in the year, against a proportion of a cost incurred in previous year.

3.

Other Considerations

Cost is a major consideration, but there may also be other hidden costs which need to be considered. It may be more cost effective to retain the existing armory when examined in terms.....

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