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 net present value (NPV), internal rate of return (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.
Answer the following:
- Based on your calculations, should EEC acquire the supplier? Why or why not?
- Which of the techniques (NPV, IRR, payback period) is the most useful tool to use? Why?
- Which of the techniques (NPV, IRR, payback period) is the least 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 are less than $500,000 per year
(c) EEC must pay more than $2 million for the supplier.
See attached file.
Subject: Feasibility of acquisition of supplier
This memo is to present feasibility for acquisition of one of the company's largest suppliers of component parts. The supplier has approached EEC for a possible purchase by the company. We believe that we can buy the supplier for $2 million. By the purchase of this supplier EEC can expect to save $500,000 every year. EEC's cost of capital is 14%. Using this information we have evaluated financials like net present value, internal rate of return and payback period for the deal. These are tools of capital budgeting which is a process of deciding whether or not a particular investment should be undertaken.
Net Present Value- Net present value is the present value of cash flows which would be generated by buying the supplier after deducting the initial investment. This technique of capital budgeting is very reliable as it takes into consideration time value of money. The first step involved in calculation of NPV is to determine the present value of cash inflows from the buyout. From this value initial investment on the project is subtracted to arrive at net present value. With initial investment of $ 2 million EEC would be able to save $500,000 annually for next 10 ...
The solution analyzes the feasibility of acquiring a supplier. It also calculates the NPV, IRR and payback for the investment opportunity.