The President of EEC recently called a meeting to announce that one of the firm’s largest suppliers of component parts has approached EEC about a possible purchase of the supplier. The President has requested that you and your staff analyze the feasibility of acquiring this supplier. Discuss the following:
- What information will you and your staff need to analyze this investment opportunity?
- What will be your decision-making process? Discuss and evaluate the different techniques that could be used in capital budgeting decisions.
- Specifically, discuss how the time value of money affects capital budgeting. Capital budgeting differs from regular budgeting in that capital budgeting is for large investment decisions like plant expansion. The regular budgeting is for your day-to-day operations decisions.
- Which do you think EEC should use? Why?
Based on the following information, calculate net present value (NPV), internal rate of return (IRR), and payback for the investment opportunity:
- EEC expects to save $500,000 per year for the next 10 years by purchasing the supplier.
- EEC’s cost of capital is 14%.
- EEC believes it can purchase the supplier for $2 million.
Answer the following:
- Based on your calculations, should EEC acquire the supplier? Why or why not?
- Which of the techniques (NPV, IRR, or payback period) is the most useful tool to use? Why?
- Which of the techniques (NPV, IRR, or payback period) is the least useful tool to use? Why?
- Would your answer be the same if EEC’s cost of capital were 25%? Why or why not?
- Would your answer be the same if EEC did not save $500,000 per year as anticipated?
- What would be the least amount of savings that would make this investment attractive to EEC?
- Given this scenario, what is the most EEC would be willing to pay for the supplier?
Prepare a memo to the President of EEC that details your findings and shows the effects if any of the following situations are true:
- EEC’s cost of capital increases.
- The expected savings are less than $500,000 per year.
- EEC must pay more than $2 million for the supplier.