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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EEC: Analysis of the Project
Date: December 12, 2008
To: President, EEC
From: Project Manager, EEC
Subject: Analysis of the Project
EEC is considering a new project which consists of acquiring a supplier of the company. In fact, one of our largest suppliers of the component parts has approached us regarding a probable purchase of the supplier. Thus, this memo analyzes the profitability of the purchase. For this purpose, the net present value, internal rate of return and payback period of the purchase have been calculated. It is an important investment opportunity for the firm and this new project proposal has been analyzed with the help of the three capital budgeting methods.
In this memo, the effects of the different changes like the change in the cost of capital, the change in the amount of the expected savings and the change in the amount of the initial cash outflows for the purchase of the supplier are considered and as a result, the change in the decision for accepting or rejecting the project is also changed. Initially, the payback period, net present value and internal rate of return are computed and after that the effects of these changes on the three are considered and the revised Payback, NPV and IRR are calculated. The cash outflow is $2,000,000 for the purchase of the supplier. The annual cash inflows are $500,000 over the economic life of the project. The expected life of the project is 10 years.
The payback period method is the most popular and widely recognized traditional method of evaluating capital expenditure proposals.
It recognizes that recovery of the original investment in the shortest period is an important element while appraising capital expenditure decisions. The pay back period is the length of time required to recover the initial cost of the project. In other words, it is an expression of how long it will take to recover the initial outlay on an investment from its cash flow returns. The pay back period can be calculated in two different solutions.
1. When annual cash inflows are equal: When cash inflows generated by a project per year are equal or constant, the pay back is computed by dividing the initial investment or cash outlay by the net annual cash inflows. Symbolically, it can be represented as (Shim & Siegel, 2000)
Pay back period = Initial investment / Net annual cash inflows.
2. When Annual Cash inflows are ...
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