TO: EEC President
FROM: Lela Keel, Financial Analyst for EEC
DATE: February 05, 2011
SUBJECT: Possible Investment
The President of Eddisons Electronics Company (EEC) has asked me and my staff to investigate the viability of the company purchasing a new supplier. By purchasing this supplier the company anticipates over the next 10 years they will save $500,000 per year. The company thinks they can obtain the investment for $2,000,000 with the company cost of capital being 14%. Based on these determinations, as well as others presented by the President, the company would like me to calculate the NPV (Net Present Value), IRR (Internal Rate of Return), and the period of payback for the investment opportunity. These calculations will be done in Excel in order for me to recommend whether the anticipated investment would be of value to the company. Once the recommendation is made I will provide a reason as to why or why not the investment decision should be made. The NPV, the IRR, and the Payback Period can all be useful tools in making a decision whether to go forward or not with the investment decision, but once the calculations are done on the feasibility of the investment I will identify which of these tools was most useful to me in making the recommendation. Also, to be discussed will be different measurements that the company may encounter with the investment, such as if there were an increase in the cost of capital for the company, if the company’s anticipated savings from the investment were less, and if the company were to pay more for the investment. With all this in mind I will make recommendations so that the company will know how they may financially suffer or financially benefit from the investment.
Net Present Value (NPV)
The NPV is a means of determining the risk of the investment for the company. This method is often referred to as the most consistent technique for determining the feasibility of the investment since it will show the actual value for company in taking on the venture. The purpose of calculating the NPV for the investment will be to see if it will positively or negatively affect the company. In order to recommend that the investment would be of value to the company the venture rate would need to be positive, since if the rate of the venture were negative the investment would be of no value to the company (Baker, 2000). In this scenario the investment for the company would be $2,000,000, and the company anticipates saving over the next 10 years $500,000 per year, with the capital cost being 14%. The NPV calculated in excel would be $1,754,385.96. Now we subtract $1,754,385.96 from the $2,000,000 that the company paid for the investment which equals a total of $245,614.04. The investment’s NPV is a positive number, so the venture should be taken on. I believe with just the NPV being calculated the investment should be taken as it would improve the value of the company. No let’s calculate and take a look at the Internal Rate of Return (IRR) of the investment.
Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is another method utilized to establish if the investment would be of value to the company. The IRR calculation purpose is to figure out the rate of return for the investment in which the company will need to breakeven while taking the cost of capital into consideration. It will be employed in this case to decide upon as to whether to accept the positive NPV of the investment or reject it all together. It does this by serving to provide the company with a percentage of profitability from the investment and it will also provide the company with the results needed to pinpoint whether the investment will sufficiently meet the associated costs of capital. If the IRR percent is superior to the initial 14% cost of capital then the investment would be okay to accept (Yost & Carreiro, 1999). In this scenario the investment for the company would be $2,000,000, and the company anticipates over the next 10 years they will save $500,000 per year, with the capital cost being 14%. The IRR calculated in Excel shows the company will earn a 21% rate of return on the investment. With that being said, since the IRR rate is 21% and it is superior to that of the initial capital cost of 14% for the company, therefore, I believe the venture should be taken on as it would be of value to the company. Now let’s calculate and look at the period of payback for the company in taking on the venture.
The payback period is a tool that will be utilized to establish the acquired time duration for the company to recuperate its initial cost of $2,000,000 for the investment. In other words, the payback period will verify how long it will be until the company has recovered their $2 million for the initial investment, and once this is done any revenue coming in from the investment will be for the company. The reason for calculating the period of payback for the company will be to demonstrate that all things are equivalent in estimating the investment. However, a shorter period of payback for the investment is all the better for the company. Calculation of the payback period is relatively simple you just sum up the investment’s cash flows for a given period, which would be annually for this particular investment, until the sum is equal to the initial investment of $2,000,000 (Garrison, Noreen, & Brewer, 2010). By taking the initial investment of $2,000,000 and dividing it by the yearly cash flows of the investment which is $500,000, my calculation on the Excel Spreadsheet comes up to a total of 4 years it will take for the company’s investment to be paid for and start generating money for the company. In my opinion this is a short payback period when you take into consideration the total amount paid for the investment, so based on this calculation the investment would be of value to the company.
Changes in Investment Opportunity
Now let’s take a look at the cost of capital for the company being increased to 25%. Looking at the NPV of the investment being $400,000 with the 25% increase in the company cost of capital, the investment could still be of value for the company. However, the IRR would still be 21% which is less than the 25% increase in the cost of capital, so the venture should not be taken on since the cost of capital is higher than the IRR for the investment. Now let’s look at a different savings for the company per year other than $500,000. Assume that the company anticipates saving $400,000 per year for 10 years on the investment the IRR would be negative 15%. With this being calculated the company would not want to undertake this investment with a savings over only $400,000 per year over the next 10 years.
Changes in Effects of Calculations
As you can see the effect of the company not saving an anticipated $500,000 per year over the next 10 years on the investment will cause the IRR to bring back a negative figure, and this is not good for the company since the venture will be of no value to the company. If the amount the company has to pay for the investment is more than the anticipated $2,000,000 the venture will be of no value to the company either, since the NPV will be lower and it will take longer to payback the investment, which could financially hurt the company in the long run since the value of the investment will go dramatically down and it will take longer for the company to recuperate from the investment and start earning money off the investment. In addition, the company should not put more cost of capital into the investment opportunity than the previously set amount of 14%. This is because of the cost of capital increases the IRR will increase which in return will make the investment of no value to the company. The company only needs to make investments that will increase the value of the company over time, and this one will, but only if the initial numbers of the company saving $500,000 per year over a 10 year period, the cost of capital for the company being 14%, and the company invests no more than $2,000,000 on the venture. Investment decisions can take time for the company to conclude on, but calculating accurate figures and knowing what value the investment will bring to the company will allow for more confident decisions to be made.
The three capital budgeting methods, NPV, IRR, and Payback Period, calculated in the attached Excel Spreadsheet are most used today for company’s who want to analyze the feasibility of taking on an investment. Each method can be used by the company to formulate a confident conclusion on either to allow or refuse the investment of the supplier (Baker, 2000). However, out of the three methods discussed I find that the IRR is the most useful tool to use to conclude whether the investment would be of value to the company. This is because, as previously stated, if the IRR is above the anticipated cost of capital then the investment should be taken on, and at the 14% cost of capital for the company in taking on the investment a 21% IRR is brought back to the organization, and this is good for the value of the company in that the return rate would be well above the initial cost of capital. The NPV is thought to be less perceptive since the measurement of the investments interest rate is not calculated with this method. It only gives an assessment of the anticipated amount of dollars that would be generated from the proposed investment. With the IRR method financial analysts are able to measure the outcome of an investment by the annual rate of return (Baker, 2000). The payback period for the company would be 4 years, which is good since the initial cost for the investment would be $2,000,000 and it would only take 4 years for the company to gain back its initial costs of the venture. After calculating the given measurements of the investment for the company it is my recommendation to go forward with the venture as long as the company stays with the initial estimate of paying $2,000,000 for the investment, saving $500,000 over 10 years with the investment, and the company’s cost of capital remains at 14%. The analyzing methods discussed should be used in order for relevant information to be obtained so that a wise and confident decision can be made since the financial success of the company is at risk when making the investment decision.
Baker, S. (2000). Measures for evaluating investments: NPV and IRR. Retrieved from http://hadm.sph.sc.edu/courses/econ/invest/invest.html
Garrison, R., Noreen, E., & Brewer, P. (2010). Managerial accounting, (13th ed.). New York, NY: McGraw-Hill Irwin.
Yost, C., & Carreiro, R. (1999). Invest FAQ, Subject: Analysis – Internal Rate of Return (IRR). Retrieved from http://invest-faq.com/articles/analy-int-rate-return.html