The President Of EEC Recently Called A Meeting To Announce

The President Of Eec Recently Called A Meeting To Announce That One Of

The President Of Eec Recently Called A Meeting To Announce That One Of

The president of EEC has announced a potential acquisition of a supplier that could significantly impact the company's operations and financial performance. EEC is considering purchasing its largest component supplier, which has approached the company with this opportunity. The core financial data indicates that EEC expects to save $500,000 annually over the next 10 years due to this acquisition. The company's current cost of capital is 14%, and the desired purchase price is $2 million.

This scenario requires a comprehensive analysis of the investment's viability, utilizing key financial evaluation techniques: Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period. It is essential to determine whether the purchase is financially justifiable based on these metrics, to identify which tool provides the most relevant insights, and to evaluate how changes in critical assumptions might alter the decision.

Paper For Above instruction

Assessing whether EEC should acquire the supplier involves a detailed financial analysis using NPV, IRR, and payback period. These tools enable decision-makers to quantify the investment's benefits relative to its costs and risks, thereby providing a solid basis for strategic decisions.

Financial Analysis: Calculations of NPV, IRR, and Payback Period

The assessment begins with calculating the Net Present Value (NPV), which measures the difference between the present value of expected cash inflows and the initial investment. The annual savings of $500,000 over 10 years, discounted at the company's cost of capital of 14%, serve as the cash inflows.

The formula for NPV is:

NPV = ∑ (Cash inflow / (1 + discount rate)^year) - Initial Investment

Using a financial calculator or spreadsheet, the present value (PV) of the savings can be estimated by calculating the Present Value of an Annuity:

PV = Payment × [1 - (1 + r)^-n] / r

Where:

  • Payment = $500,000
  • r = 0.14
  • n = 10

Calculating:

PV = 500,000 × [1 - (1 + 0.14)^-10] / 0.14 ≈ 500,000 × 5.216 ≈ $2,608,000

Subtracting the purchase cost of $2 million gives an approximate NPV:

NPV ≈ $2,608,000 - $2,000,000 = $608,000

Since the NPV is positive, this indicates the investment is financially viable under current assumptions.

Calculating the Internal Rate of Return (IRR)

The IRR is the discount rate at which the NPV equals zero. It can be estimated by interpolating between discount rates or using a financial calculator or spreadsheet function. Based on the cash flows, the IRR exceeds the company's current cost of capital (14%), likely around 20-21%, further supporting the investment's attractiveness.

Payback Period Analysis

The payback period is the time required to recover the initial investment from cash inflows. With annual savings of $500,000, the payback period is:

Payback Period = $2,000,000 / $500,000 = 4 years

This is within the 10-year horizon, indicating a good liquidity profile for the investment.

Decision-Making: Which Technique is Most Useful?

Among the three, NPV is generally considered the most comprehensive and reliable assessment tool. It accounts for the time value of money, provides a dollar value that reflects added value to the firm, and directly measures profitability. IRR is useful for understanding the rate of return but can be misleading if multiple IRRs exist or if the cash flow pattern changes. The payback period, while simple and easy to interpret, ignores the time value of money and cash flows beyond the payback point, making it less comprehensive.

Impact of Higher Cost of Capital (25%)

If EEC's cost of capital increases to 25%, the present value of future savings would decrease, reducing the NPV. Recalculating PV with a 25% discount rate:

PV = 500,000 × [1 - (1 + 0.25)^-10] / 0.25 ≈ 500,000 × 3.102 ≈ $1,551,000

NPV now becomes:

$1,551,000 - $2,000,000 = -$449,000

The negative NPV suggests the acquisition would no longer be attractive at the higher capital cost, emphasizing the sensitivity of investment decisions to the discount rate.

Effect of Reduced Savings

If projected savings fall below $500,000 annually, the investment's attractiveness diminishes. To identify the minimum acceptable savings, we set NPV to zero and solve for annual cash inflow:

Initial Investment = PV of savings

2,000,000 = Payment × [1 - (1 + 0.14)^-10] / 0.14


=> Payment = 2,000,000 / 5.216 ≈ $383,500

This indicates that annual savings should be at least $383,500 for the project to break even, making this the minimum threshold for the investment to be considered advantageous.

Maximum Willingness to Pay

Based on the discounted cash flows, EEC would be willing to pay up to the present value of the expected savings, approximately $2.608 million, including the NPV calculation above. Paying more than this would reduce or eliminate the project’s value creation.

Implications and Recommendations

The analysis suggests that under current assumptions, the acquisition is financially justified, with a positive NPV, IRR well above the cost of capital, and a reasonable payback period. However, sensitivity analyses reveal that increases in the company's cost of capital or decreases in expected savings could negate these benefits.

In light of these findings, the company should proceed with caution. It is advisable to conduct ongoing due diligence, reassess assumptions periodically, and consider potential risks and variability in savings. If the cost of capital rises significantly or if savings diminish, the project should be re-evaluated, and alternative investment options should be explored.

In conclusion, the decision to acquire the supplier should hinge primarily on the NPV outcome, supported by IRR and payback period analyses, which corroborate the investment's profitability under current conditions but highlight sensitivity to key variables.

References

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