Problem:
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. Based on the following information, calculate NPV, 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.
Based on your calculations, should EEC acquire the supplier? Why/Why not? Which of the techniques (NPV, IRR, Payback Period) is the most useful tool to use? Why? Would your answer be the same if EEC's cost of capital were 25%? Why?/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 detailing your findings and showing the effects if
(a) EEC's cost of capital increases
(b) the expected savings is less than $500,000 per year and
(c) EEC must pay more than $2 million for the supplier.