EEC should acquire the supplier based on the calculations on NPV, IRR and Payback period. The investment has a positive NPV which shows that the company gains value for its money. The results show that the company will have an NPV of 608057.8231 at the end of the ten years and using the cost of capital as the discounting rate. The company, therefore, stands to benefit if it acquires the supplier at $2,000,000. According to IRR calculations, the company should acquire the supplier since the IRR is higher than the cost of capital (Berk & DeMarzo, 2014). The company has an IRR of 21.41% which is higher than the cost of capital and therefore the investment has higher returns for the company than its cost of capital of 14%. According to the payback period calculations, the investment will have repaid back the entire cost in four years (Crosson & Needles, 2014). Once the initial capital is fully recovered, the company will continue making significant savings from the project for six years. The acquisition is therefore worth pursuing since the company will benefit from such an initiative.
The acquisition of the supplier was evaluated using NPV, IRR and payback period. One issue of concern is to determine the superiority of each capital budgeting technique used to evaluate the project. Holding all other factors constant, the use of NPV and IRR leads to similar findings (Ross, Westerfield & Jordan, 2016). However, the IRR has a single discount rate that can be used by EEC to evaluate the acquisition of the supplier. The IRR has limitations for long-term projects whose discount rate will change. Projects that lack additional investments and with a constant discount rate and cash flows can be evaluated with IRR. If the discount rate remains the same for the ten years, the IRR will be superior to NPV. The IRR is highly used due to its simplicity since there are fewer assumptions and less complex than NPV (Jordan, Westerfield & Ross, 2011). Its superiority arises from its ability to simplify the investment to a single value that can be used by the management to determine the viability of the project.
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The NPV, IRR and payback period are tools used in capital budgeting to determine the viability of an investment. The three have their strong and weak points and highly dependent on the project. The NPV, for example, can be used in projects with uneven cash flows and discount rates. Similarly, it can be used for projects that include additional investment in subsequent years. IRR, on the other hand, is appropriate for situations with even cash flows and a constant discount rate (Taillard, 2013; Welch, 2009). The technique best applies to projects with a short lifespan. The payback period, on the other hand, is used to determine the number of years that an investment will have repaid the entire initial investment. In EEC case, the payback period shows the number of years that the company will have recovered the two million used to acquire the supplier.
The payback period is the least useful tool for capital budgeting. Some of the reasons for the limitation include disregard for the time value of money for each investment and considers the time taken to recover the invested amount. Similarly, it disregards the associated risk of each project and financing issues. Payback period should not be used in isolation since it lacks an explicit criterion to be used by the management for decision making (Weygandt, Kimmel & Kieso, 2018). Another limitation of the payback period is that it ignores additional cash flows that arise after the payback period thus does not consider the profitability of the project.
The answers will not be the same if the cost of capital for EEC was 25%. According to the calculations, the NPV will have a negative value of 214748.40 is the cost of capital increased from 14% to 25%. Acquisition of the supplier will therefore not be feasible since the company’s present value of the cost for acquiring the supplier is more than the present value of the revenues at 25%. The cost of capital, in this case, is very high and therefore the investment is not feasible. The cost of capital is exorbitant for EEC and therefore the acquisition of not worth investing in. At such a cost of capital, the company is better off not acquiring the investor and instead it should identify other sources of capital with a lower cost of capital (Berk & DeMarzo, 2014). The IRR is also lower than the cost of capital and therefore the company should not acquire the supplier since the cost of capital is higher than the expected return and therefore the project is likely to be loss-making. If the cost of capital changes to 25% the payback period is unaffected by the change and therefore remains the same.
A change in the amount saved by EEC will affect the decision on whether the company should acquire the suppl.ier or not. If EEC saves more than $500,000 per year, it should pursue the project. If the savings are lower than the said amount, it should determine the IRR and NPV of the project using the new cash flows. If the NPV is positive and the IRR is more than the cost of capital, it should continue with the acquisition. However, if the NPV is negative and the IRR is lower than the cost of capital, EEC should not acquire the supplier (Berk & DeMarzo, 2014). An increase in the savings will reduce the payback period while a decline will increase the payback period for the investment.
If the savings increase by $200,000 per year, the NPV for the investment at a cost of capital of 14% will be $1651280.95. Similarly, the NPV at a cost of capital of 25% will be $499352.29 implying that the investment can be pursued even at a higher cost of capital. The IRR for the acquisition will be 32.98%. A decline of the savings to say $380,000 per year will lead to a negative NPV of 17876.05 at a discount rate of 14% implying that the project is not worth investing in and therefore EEC should not acquire the supplier. According to the IRR, the same conclusion can be drawn since the IRR from annual savings of $38,000 is 13.77% which lower than the cost of capital and therefore the project not profitable for the company and should not be pursued.
The least amount of savings that EEC should make to make the investment attractive should be $383,427.5 per year. The savings will allow for an NPV of 2.182 and an IRR of 14% which is the same as the cost of capital. Annual savings equivalent to this amount will ensure that the company is not making any loss even though the investment has a rate of return which is the same as the cost of capital. The payback period for the investment if the savings decline to $383,427.5 will increase to 5.2 years.
Given the scenario, EEC can pay the supplier the $2,000,000 as long as it can make annual savings that can ensure that its NPV is positive and the IRR is higher than the cost of capital. The acquisition of the supplier should generate value for the company and increase its profitability. The company can also pay a higher amount to the supplier as long as the NPV of the project remains positive and the IRR is higher than the cost of capital (Welch, 2009). However, EEC should be careful not to overpay the company thus affecting is the financial position.
Memo
To: The President
From: The CFO
Subject: Acquisition of supplier
A detailed capital budgeting assessment involving NPV, IRR and payback period was conducted as instructed by the board to determine the viability of acquiring the supplier. The aim of the acquisition is to save on current cost and therefore improve the performance of the company. The assessment used 14% as the cost of capital and evaluated the net present value, the internal rate of return and the payback period of the investment for a cost of $2,000,000 in ten years. According to the analysis, the acquisition had a positive NPV, a higher IRR than the current cost of capital and the payback period was four years.
The assessment further determined the effect of an increase in the cost of capital from 14% to 25%. From the calculations, the project had a negative NPV and the IRR is lower than the cost of capital. The project, therefore, cannot be pursued if the cost of capital increased to 25%. The payback period, however, remained the same since annual savings and the initial amount to be paid to the supplier remained unchanged.
Payments to the supplier exceeding $2,000,000 will affect the net present value, the IRR and the payback period. An increase in the amount paid will reduce the NPV and the IRR and if it goes beyond $2,600,000 will lead to a negative NPV thus the project will not be worth undertaking. The IRR at such an investment will also be lower than the cost of capital and the payback will increase. EEC should, therefore, limit the amount paid to the supplier to less than $2,600,000. However, paying such an amount will have an adverse effect on the return of the investment.
References
Berk, J., & DeMarzo, P. (2014). Corporate finance (3rd ed.). Boston: Pearson.
Crosson, S. and Needles, B. (2014). Managerial accounting . [Mason, Ohio?]: South-Western/Cengage Learning.
Jordan, B., Westerfield, R., & Ross, S. (2011). Corporate finance essentials . New York: McGraw-Hill Irwin.
Ross, S., Westerfield, R., & Jordan, B. (2016). Fundamentals of corporate finance (11th ed.). New York: McGraw-Hill Higher Education.
Taillard, M. (2013). Corporate finance for dummies . Hoboken, NJ: John Wiley & Sons, Incorporated.
Welch, I. (2009). Corporate finance . New York, N.Y: Prentice Hall.
