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Memorandum

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The President of EEC recently called a meeting to announce that one of the firm's largest suppliers of component parts has approached EEC about a possible purchase of the supplier. The President has requested that you and your staff analyze the feasibility of acquiring this supplier. Based on the following information, calculate NPV, IRR, and Payback for the investment opportunity.

EEC expects to save $500,000 per year for the next 10 years by purchasing the supplier.
EEC's cost of capital is 14%.
EEC believes it can purchase the supplier for $2 million.
Based on your calculations, should EEC acquire the supplier? Why/Why not? Which of the techniques (NPV, IRR, Payback Period) is the most useful tool to use? Why? Would your answer be the same if EEC's cost of capital were 25%? Why?/Why not? Would your answer be the same if EEC did not save $500,000 per year as anticipated? What would be the least amount of savings that would make this investment attractive to EEC? Given this scenario, what is the most EEC would be willing to pay for the supplier?

Prepare a memo to the President of EEC detailing your findings and showing the effects if
(a) EEC's cost of capital increases
(b) the expected savings is less than $500,000 per year and
(c) EEC must pay more than $2 million for the supplier.

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Solution Preview

The response addresses the queries posted in 2240 words with references.

// Prior to analyzing the feasibility of investment opportunity, first of all, we will discuss about the capital budgeting methods in a general way, so that we can get proper knowledge about these techniques, i.e., NPV, IRR and payback period. So initially, we will write about techniques under the heading of introduction, for example //

Memorandum

To: EEC President

From: XYZ

Date: 25/01/2010

Subject: Analyze the feasibility of acquiring the supplier

Introduction:

NPV: For the purpose of evaluating the investment proposals, this is the best discounted technique. It is a technique that ponders the difference between present value of future cash inflows and the present value of cash outflows. In general sense, this technique is mainly used to weigh the elements of trade off between investment outlays and future benefits of equivalent terms (Groppelli & Nikbakht, 2000). With this method, one can easily compare the investment proposals with relative profit earning ability. In addition to this, this technique analyzes the proposal effects on the shareholders wealth in a best efficacious way. On the whole, the concept of NPV has a build in earning requirements in addition to improvement of the investment.

IRR: This is another most vital technique for appraising the budgeting proposals. It is the rate at which the present value of expected cash inflows are equated with the present value of expected cash outflows. IRR is also defined as the rate at which the net present value of investment is zero. It is a profit oriented concept and helps in selecting those proposals which are expected to earn more than the minimum rate of return. With this, it is evident that IRR aids in attaining the maximization of shareholders' funds target.

Payback: Payback method is the most easygoing method for evaluation of capital expenditure. It refers to the length of time required to recover the project's initial investment or cost. In this technique, time factor plays a determinative role as the decisions of accepting or rejecting the investment proposal is based on the time period. As per this investment appraising technique, original investment must be recovered within shortest period of time (Groppelli & Nikbakht, 2000). This method is advantageous for the company as the components of cost involved in the application is quite low than other techniques. As well as, it is a simple to operate and easy to understand technique that greatly assists the firms having less capability in terms of skills, manpower, etc.

//Above, we have covered capital budgeting models that assist in analyzing the investment feasibility so that the decision related to accepting or rejecting proposals can take place easily. As per the directions, now in this part, we will also show the calculations of Payback period, Net present value and IRR for this project, in order to evaluate the investment opportunity.//

The decision related to accepting or rejecting the proposal takes on the basis of the calculations given below. According to the payback technique, EEC should acquire the supplier as it is profitable for it. As compared to economic life, the calculated payback period is shorter, that is the reason the proposal should be accepted (Groppelli & Nikbakht, 2000), as this technique reflects that EEC is able to recover its initial investment in the shortest period, i.e., 4 years. With this, it is evident the project whose duration of ...

Solution Summary

The response addresses the queries posted in 2240 words with references.

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