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Eddison Electronic Company Eec Provides Electricity For Several Stat

Eddison Electronic Company (EEC) is evaluating a potential capital investment regarding the purchase of a supplier expected to generate annual savings of $500,000 over the next ten years. The company considers purchasing the supplier for $2 million, with a current cost of capital of 14%. This memo assesses the advantages and disadvantages of different investment appraisal methods—Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period—and recommends the most appropriate method for EEC to use. Additionally, it examines how changes in the company’s cost of capital and anticipated savings impact the decision-making process and whether EEC should proceed with the acquisition under various scenarios.

Paper For Above instruction

The decision to undertake a capital investment is fundamental for organizations seeking sustainable growth and operational efficiency. Eddison Electronic Company’s consideration to acquire a supplier, projected to save $500,000 annually over ten years, requires a critical analysis of valuation methods to ensure that the decision aligns with the company’s financial objectives and risk appetite. The primary methods to evaluate such an investment are Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period, each with distinct advantages and limitations.

Advantages and Disadvantages of Investment Appraisal Methods

The Net Present Value method is widely regarded as a comprehensive approach because it estimates the absolute value added to the firm by discounting future cash flows at the company’s cost of capital. An advantage of NPV is that it accounts for the time value of money and provides a clear criterion: a positive NPV indicates the project should be undertaken. It directly measures the expected increase in wealth. However, a limitation is that NPV relies heavily on accurate estimates of future cash flows and the discount rate, which introduces uncertainty, especially over long horizon periods.

The Internal Rate of Return (IRR) method calculates the discount rate at which the present value of future cash inflows equals the initial investment, effectively representing the project's break-even rate of return. IRR is advantageous because it provides a percentage figure that is easy to interpret, especially for comparison against the company's required rate of return or cost of capital. Nonetheless, IRR can produce multiple values in some cases (for projects with unconventional cash flows), and it may lead to incorrect decision-making when used alone, particularly when comparing mutually exclusive projects or projects with different durations.

The Payback Period method determines how long it takes for the initial investment to be recovered from cash inflows. Its simplicity and ease of calculation make it attractive, especially for firms with liquidity concerns or risk aversion. However, it does not consider the time value of money or cash flows beyond the payback point. As a result, it ignores the profitability of the investment after the payback period, which can lead to suboptimal decisions.

Choosing the Appropriate Method

Given the strengths and weaknesses of each approach, EEC should prioritize NPV for decision-making because it directly measures value addition, considers the time value of money, and aligns with shareholders’ wealth maximization. While IRR offers a quick percentage-based estimate, its potential for multiple solutions and less reliability in cases of non-conventional cash flows make it less preferable on its own. The payback period, while useful for quick liquidity assessment, should supplement the NPV analysis rather than serve as the primary criterion.

Impact of the Cost of Capital

If EEC’s cost of capital increases from 14% to 25%, the NPV of the proposed investment would decrease because higher discount rates reduce the present value of future savings. A higher required rate of return might turn what was once a positive NPV project into a negative one, thereby discouraging the investment. Hence, if the cost of capital escalates significantly, EEC’s previous positive valuation might no longer hold, and the investment might become unattractive unless the savings increase proportionally.

Effect of Actual Savings on Investment Decision

If EEC does not realize the projected annual savings of $500,000, the attractiveness of the project diminishes. For the investment to remain financially viable, the annual savings must at least equal the initial investment’s present value. Calculating the minimum annual savings needed to justify the $2 million investment at a 14% discount rate over 10 years involves solving for the annual cash flow that yields an NPV of zero. Using the Present Value of an annuity formula, the minimum annual savings (S) can be estimated as:

\[ S = \frac{PV \times r}{1 - (1 + r)^{-n}} \]

Where:

- PV = $2,000,000

- r = 14% or 0.14

- n = 10 years

Plugging in the numbers:

\[ S = \frac{2,000,000 \times 0.14}{1 - (1 + 0.14)^{-10}} \]

\[ S ≈ \frac{280,000}{1 - (1.14)^{-10}} \]

\[ S ≈ \frac{280,000}{1 - 0.2697} \]

\[ S ≈ \frac{280,000}{0.7303} ≈ 383,695 \]

Therefore, the minimum annual savings needed to justify the investment is approximately $384,000. If EEC’s actual savings fall below this threshold, the project’s NPV becomes negative, and the investment is no longer attractive.

Conclusion

Based on the analysis, EEC should primarily employ the NPV method to evaluate the investment, as it provides the most comprehensive measure of value addition, considering the time value of money. If the company’s cost of capital increases to 25%, the NPV of the project likely turns negative unless savings increase significantly, and hence, the investment may no longer be justified. Furthermore, if actual savings are less than roughly $384,000 annually, the project would not meet the minimum required threshold, rendering it unattractive. Under current assumptions, with expected savings of $500,000 per year at a 14% discount rate, the investment appears financially sound, and EEC should consider proceeding with the purchase. However, it must include contingency plans for lower-than-expected savings or increased capital costs to mitigate potential risks.

References

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