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Eddison Electronic Company (EEC) is contemplating a capital investment decision involving the potential purchase of a supplier, which is expected to lead to annual savings of $500,000 over the next 10 years. The purchase price is estimated at $2 million, and EEC's current cost of capital is 14%. This memo evaluates the advantages and disadvantages of investment appraisal methods—Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period—and recommends the most appropriate approach for EEC under current and altered circumstances. The analysis also considers the impact of changes in the cost of capital and annual savings on the investment decision.

Advantages and Disadvantages of Investment Appraisal Methods

Net Present Value (NPV)

The NPV method calculates the difference between the present value of cash inflows (savings) and outflows (initial investment). Its primary advantage is that it provides a dollar amount measure of value added to the firm, directly reflecting profitability. NPV accounts for the time value of money and considers the cost of capital, making it a comprehensive approach for investment appraisal. Its disadvantage, however, is that it requires an estimate of the discount rate and future cash flows, which can be uncertain or difficult to forecast accurately. Additionally, NPV can be less intuitive for managers to interpret compared to percentage measures.

Internal Rate of Return (IRR)

The IRR method determines the discount rate that makes the NPV of the project zero. Its main advantage is that it provides a percentage return, which is easy to compare with the company's required rate of return or cost of capital. IRR is useful for ranking projects and making quick decisions. Nonetheless, IRR can be misleading in situations with non-conventional cash flows or mutually exclusive projects. It also assumes reinvestment of interim cash flows at the IRR, which may not be realistic.

Payback Period

The payback period measures how long it takes for the project to recover the initial investment from cash inflows. Its simplicity is an advantage, making it accessible for quick assessments. However, it ignores the time value of money, cash flows beyond the payback period, and does not measure profitability. It may lead to rejecting projects with long-term benefits and provides no indication of the project’s overall value.

Recommendation Based on NPV, IRR, and Payback Period

Given the data, EEC should primarily utilize the NPV method for its investment decision. NPV directly quantifies the value addition from the project in dollar terms, aligning with the goal of maximizing shareholder value. Since EEC's cost of capital is 14%, the NPV calculation would involve discounting the expected annual savings of $500,000 over 10 years at this rate. If the net present value is positive, the investment is financially viable.

IRR can serve as a secondary measure, providing the percentage return. If the IRR exceeds the cost of capital (14%), it supports proceeding with the investment. However, IRR can sometimes overstate profitability, especially if cash flows are uneven or if comparison with other projects is necessary.

The payback period offers a quick assessment of liquidity and risk. For this project, the payback period is approximately four years ($2 million / $500,000 per year). While simple, it does not consider discounting or cash flows beyond year 4, so it should only support the primary NPV analysis rather than be the sole criterion.

Impact of Changing the Cost of Capital

If EEC’s cost of capital rises to 25%, the discount rate used in the NPV calculation increases, reducing the present value of future savings. This decrease may potentially turn a positive NPV negative, making the project less attractive or even unviable. Conversely, a higher cost of capital raises the threshold return needed for an investment to be acceptable, emphasizing the importance of accurate discount rate selection and risk assessment.

Effect of Reduced Savings on Investment Attractiveness

If the annual savings fall below the projected $500,000, the NPV will decrease proportionally. To determine the minimum savings required to make the project attractive, EEC must ensure the NPV remains positive. For example, with a $2 million investment and a 14% discount rate over 10 years, the present value of cash inflows must at least equal $2 million. Calculations show that the minimum annual savings needed would be approximately $357,000. Savings below this threshold would render the project unattractive based on NPV criteria.

Conclusion

Given the current data with $500,000 annual savings, a 14% discount rate, and a $2 million investment cost, the NPV method indicates the project is likely profitable, supporting acquisition. The IRR, which would need to exceed 14%, probably confirms this, while the payback period of around four years aligns with acceptable risk profiles. If the cost of capital increases to 25%, the project’s viability diminishes and warrants re-evaluation. Moreover, if projected savings are significantly less, the calculated minimum savings threshold emphasizes the importance of accurate forecasting. Ultimately, based on the current assumptions and calculations, EEC should proceed with the acquisition to realize the anticipated benefits and enhance long-term strategic capabilities.

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