EEC's president announced that one of its largest suppliers is open to being acquired. Analyze the feasibility of acquiring this supplier using net present value (NPV), internal rate of return (IRR), and payback methods.
The following assumptions are the best knowledge at this time:
1. EEC will save $500,000 annually for 10 years.
2. Cost of capital is 14%
3. The investment to buy the supplier would be $2,000,000.
Show EEC buy the supplier? Explain.
Which method was the most useful? Least useful?
If cost of capital was 25%, would your recommendation change? Explain.
If the annual savings was lower than $500,000, would your recommendation change? Explain.
How low can the annual savings go and still make the deal attractive?
Draft a memo to the president recommending a course of action supported by your detail findings.
1. Based on your calculations, should EEC acquire the supplier? Why or why not?
Yes, the project returns a 21.4% annualized return, well above the 14% cost of capital and pays back in four years. This looks like a great project.
2. Which of the techniques (NPV, IRR, payback period) is the most useful tool to use? Why?
They are all useful. I am not sure there is a "more" useful or "most" useful. They provide different views. Payback is a conservative measure to be sure that the capital is recovered quickly. That is most useful when the forecasts are a guess and there is little data upon which to estimate cash flows in the deep future. NPV gives you the dollar amount above cost of capital and IRR tells you the annualized return (assuming the returns can be reinvested at the project rate). They both take advantage of the time value of money to make returns that are far off less influential in the decision. NPV is most helpful when the AMOUNT is important. IRR is most important if you are ...
Your discussion is 541 words and explains how each element impacts the decision, the cost of capital, the returns and the maximum price.