Information for the staffs to analyze investment opportunity:
It is necessary for the staffs to conduct research for the potential investment opportunity. This would be in the best interest of ECC for carrying out a financial evaluation on the potential investment, which involves analysis of non-financial investment aspects. Such research would lead to identification of additional cash flows associated with investment (Andor, Mohanty & Toth, 2015). Thus, ECC could obtain an insight of the short and long-term implications of the investment opportunity. In addition, the staffs are needed to analyze the non-financial aspects before taking into account the financial impact of the investment, particularly if the same does not have the ability of generating revenue. Therefore, the staffs are required to be encouraged in including discussions about the benefits and drawbacks of the investment, alignment with the overall business strategy and alternative opportunity that could be contrasted.
Decision-making process based on the evaluation of capital budgeting techniques:
The decision-making process needs to reflect the above-stated discussions and obtain possible answers for arriving at an inference. For instance, if the inference of the above discussions supports this investment opportunity along with denoting that it would exceed threshold dollar value, the next move is to complete a financial evaluation on investment. The overall financial analysis takes into account the staff accumulation of the relevant financial information into a place. The use of data is followed after this for evaluating the investment viability. Hence, the anticipated additional cash flows associated with the investment could be identified. This denotes the incremental revenues and expenditures due to investment, which would help in showing the scope of this investment in enhancing the overall performance of the organization (Bierman Jr & Smidt, 2014). In addition, the accumulated data could be assessed with the help of break-even analysis, net present value and payback analyses.
Effect of time value of money on capital budgeting:
Capital budgeting is a method where an organization intends to make long-term investment, which would generate cash inflows over the years and thus, it is signification to its planning process. Hence, it is necessary for the management to ascertain the offers paying most on its investment. In the words of Brunzell, Liljeblom & Vaihekoski (2013), time vale of money denotes a dollar in hand values higher compared to a promised dollar at a future date. Thus, the time value of money helps in providing a determination of the cash value related to a specific investment at a future time. Capital budgeting utilizes the time value of money for ascertaining the change of cash flows in future and if investment could be made in a better alternative project. Thus, EEC needs to analyze both current and future values.
Recommendation to ECC regarding whether to use capital budgeting or regular budgeting:
When any organization plans to invest in a specific project, of which the case of ECC is a probable purchase of the supplier, it might be years before the project starts fetching positive cash flows (Burns & Walker, 2015). It is necessary for ECC to understand whether the future cash inflows actually worth the investment. This is the main reason that time value of money is significant to capital budgeting. As the time value of money is of the notion that a specific sum in the current date is worth more than the same amount in a future date, it is recommended to ECC to use capital budgeting for evaluating the investment opportunity.
Recommendation to ECC whether to acquire the supplier based on the techniques of Net Present Value (NPV), Internal Rate of Return (IRR) and Payback Period (PBP):
|
Cost of Capital |
14% |
|||
|
Years |
Amount (in $) |
Discounting Factor @14% |
Discounted Cash Flows (in $) |
Cumulative Cash Inflows (in $) |
|
0 |
(2,000,000) |
1 |
(2,000,000) |
(2,000,000) |
|
1 |
500,000 |
0.88 |
438,596 |
(1,500,000) |
|
2 |
500,000 |
0.77 |
384,734 |
(1,000,000) |
|
3 |
500,000 |
0.67 |
337,486 |
(500,000) |
|
4 |
500,000 |
0.59 |
296,040 |
– |
|
5 |
500,000 |
0.52 |
259,684 |
500,000 |
|
6 |
500,000 |
0.46 |
227,793 |
1,000,000 |
|
7 |
500,000 |
0.40 |
199,819 |
1,500,000 |
|
8 |
500,000 |
0.35 |
175,280 |
2,000,000 |
|
9 |
500,000 |
0.31 |
153,754 |
2,500,000 |
|
10 |
500,000 |
0.27 |
134,872 |
3,000,000 |
|
Net Present Value |
$ 608,057.82 |
|||
|
Internal Rate of Return |
21.41% |
|||
|
Payback Period |
4.00 years |
According to the above table, it could be observed that the net present value of acquiring the supplier, which is obtained as $608,057.82. The higher the net present value of an investment, the more attractive the investment opportunity is for the organization (Chittenden & Derregia, 2015). In addition, the internal rate of return is obtained as 21.41%, which is greater than the overall cost of capital. This implies that by acquiring the supplier, ECC could maximize its overall return on investment. Furthermore, the payback period of the investment is much lower compared to the economic life of the project and an organization always expects a lower payback period for recovering its investment within shorter time span (Daunfeldt & Hartwig, 2014). Hence, from the evaluation of the above investment appraisal techniques, it is recommended to ECC to acquire the supplier, as it would help in increasing its overall return on investment.
Most useful investment appraisal tool for ECC:
From the above three techniques, net present value is the most useful tool of investment appraisal, which ECC could place as the first priority for evaluating the investment opportunity. In addition, this technique is easy to use by assuming the rate of return, which is the rate of discount that leads to a zero value (Dellavigna & Pollet, 2013). Net present value provides assumptions, which are highly realistic and it helps in evaluating long-term projects with changing cash flows and discount rates.
Least useful investment appraisal tool for ECC:
Among the three techniques, payback period is the least useful tool of investment appraisal for ECC to use, as it only denotes the amount of time to recover the initial amount of investment (Hayward et al., 2017). Thus, ECC need not consider ECC as the only investment appraisal tool for evaluating this investment opportunity.
Variation in answer with the increase in cost of capital to 25%:
|
Cost of Capital |
25% |
|||
|
Years |
Amount (in $) |
Discounting Factor @25% |
Discounted Cash Flows (in $) |
Cumulative Cash Inflows (in $) |
|
0 |
(2,000,000) |
1 |
(2,000,000) |
(2,000,000) |
|
1 |
500,000 |
0.80 |
400,000 |
(1,500,000) |
|
2 |
500,000 |
0.64 |
320,000 |
(1,000,000) |
|
3 |
500,000 |
0.51 |
256,000 |
(500,000) |
|
4 |
500,000 |
0.41 |
204,800 |
– |
|
5 |
500,000 |
0.33 |
163,840 |
500,000 |
|
6 |
500,000 |
0.26 |
131,072 |
1,000,000 |
|
7 |
500,000 |
0.21 |
104,858 |
1,500,000 |
|
8 |
500,000 |
0.17 |
83,886 |
2,000,000 |
|
9 |
500,000 |
0.13 |
67,109 |
2,500,000 |
|
10 |
500,000 |
0.11 |
53,687 |
3,000,000 |
|
Net Present Value |
$ (214,748.36) |
|||
|
Internal Rate of Return |
21.41% |
|||
|
Payback Period |
4.00 years |
From the above table, it could be evaluated that the net present value of the investment opportunity is obtained as ($214,748.36). The negative value suggests that this investment opportunity would not remain attractive with the increase in cost of capital from 14% to 25%. Although the payback period is below the economic life of the project, the internal rate of return is lower than the cost of capital. Hence, it could be stated that ECC should not opt for acquiring the supplier, if the cost of the capital increases to 25%.
Variation in answer, if the savings of ECC are less than the anticipated $500,000:
If the savings of ECC are not more than the anticipated $500,000, the following three scenarios with change in savings have been considered:
Scenario 1: Savings anticipated as $450,000
|
Cost of Capital |
14% |
|||
|
Years |
Amount (in $) |
Discounting Factor @14% |
Discounted Cash Flows (in $) |
Cumulative Cash Inflows (in $) |
|
0 |
(2,000,000) |
1 |
(2,000,000) |
(2,000,000) |
|
1 |
450,000 |
0.88 |
394,737 |
(1,550,000) |
|
2 |
450,000 |
0.77 |
346,260 |
(1,100,000) |
|
3 |
450,000 |
0.67 |
303,737 |
(650,000) |
|
4 |
450,000 |
0.59 |
266,436 |
(200,000) |
|
5 |
450,000 |
0.52 |
233,716 |
250,000 |
|
6 |
450,000 |
0.46 |
205,014 |
700,000 |
|
7 |
450,000 |
0.40 |
179,837 |
1,150,000 |
|
8 |
450,000 |
0.35 |
157,752 |
1,600,000 |
|
9 |
450,000 |
0.31 |
138,379 |
2,050,000 |
|
10 |
450,000 |
0.27 |
121,385 |
2,500,000 |
|
Net Present Value |
$ 347,252.04 |
|||
|
Internal Rate of Return |
18.31% |
|||
|
Payback Period |
4.44 years |
Scenario 2: Savings anticipated as $400,000
|
Cost of Capital |
14% |
|||
|
Years |
Amount (in $) |
Discounting Factor @14% |
Discounted Cash Flows (in $) |
Cumulative Cash Inflows (in $) |
|
0 |
(2,000,000) |
1 |
(2,000,000) |
(2,000,000) |
|
1 |
400,000 |
0.88 |
350,877 |
(1,600,000) |
|
2 |
400,000 |
0.77 |
307,787 |
(1,200,000) |
|
3 |
400,000 |
0.67 |
269,989 |
(800,000) |
|
4 |
400,000 |
0.59 |
236,832 |
(400,000) |
|
5 |
400,000 |
0.52 |
207,747 |
– |
|
6 |
400,000 |
0.46 |
182,235 |
400,000 |
|
7 |
400,000 |
0.40 |
159,855 |
800,000 |
|
8 |
400,000 |
0.35 |
140,224 |
1,200,000 |
|
9 |
400,000 |
0.31 |
123,003 |
1,600,000 |
|
10 |
400,000 |
0.27 |
107,898 |
2,000,000 |
|
Net Present Value |
$ 86,446.26 |
|||
|
Internal Rate of Return |
15.10% |
|||
|
Payback Period |
5.00 years |
Scenario 3: Savings anticipated as $385,000
|
Cost of Capital |
14% |
|||
|
Years |
Amount (in $) |
Discounting Factor @14% |
Discounted Cash Flows (in $) |
Cumulative Cash Inflows (in $) |
|
0 |
(2,000,000) |
1 |
(2,000,000) |
(2,000,000) |
|
1 |
385,000 |
0.88 |
337,719 |
(1,615,000) |
|
2 |
385,000 |
0.77 |
296,245 |
(1,230,000) |
|
3 |
385,000 |
0.67 |
259,864 |
(845,000) |
|
4 |
385,000 |
0.59 |
227,951 |
(460,000) |
|
5 |
385,000 |
0.52 |
199,957 |
(75,000) |
|
6 |
385,000 |
0.46 |
175,401 |
310,000 |
|
7 |
385,000 |
0.40 |
153,860 |
695,000 |
|
8 |
385,000 |
0.35 |
134,965 |
1,080,000 |
|
9 |
385,000 |
0.31 |
118,391 |
1,465,000 |
|
10 |
385,000 |
0.27 |
103,851 |
1,850,000 |
|
Net Present Value |
$ 8,204.52 |
|||
|
Internal Rate of Return |
14.11% |
|||
|
Payback Period |
5.19 years |
According to the above tables, ECC could acquire the supplier at S385,000, since the net present value is obtained as positive and the internal rate of return is slightly higher than the cost of capital. Hence, the attractiveness of the investment opportunity would be minimized for ECC, as the overall return would decline in line as well with the fall in anticipated savings.
Least amount of savings for increasing the attractiveness of the investment to ECC:
With reference to the above calculations, the least amount of savings that ECC could expect for increasing the attractiveness of the investment is $400,000. This is because the IRR is 1.10% greater than the cost of capital and the NPV is obtained as positive. In addition, the room for error is minimal; however, any significant miscomputation could result in serious losses for ECC.
Maximum amount that ECC would be willing to pay for the supplier:
In order to determine the maximum amount that ECC could pay for the supplier, the initial investments for acquiring the supplier are assumed as $2,500,000 and $2,600,000.
Scenario 1: Initial investment is assumed as $2,500,000
|
Cost of Capital |
14% |
|||
|
Years |
Amount (in $) |
Discounting Factor @14% |
Discounted Cash Flows (in $) |
Cumulative Cash Inflows (in $) |
|
0 |
(2,500,000) |
1 |
(2,500,000) |
(2,500,000) |
|
1 |
500,000 |
0.88 |
438,596 |
(2,000,000) |
|
2 |
500,000 |
0.77 |
384,734 |
(1,500,000) |
|
3 |
500,000 |
0.67 |
337,486 |
(1,000,000) |
|
4 |
500,000 |
0.59 |
296,040 |
(500,000) |
|
5 |
500,000 |
0.52 |
259,684 |
– |
|
6 |
500,000 |
0.46 |
227,793 |
500,000 |
|
7 |
500,000 |
0.40 |
199,819 |
1,000,000 |
|
8 |
500,000 |
0.35 |
175,280 |
1,500,000 |
|
9 |
500,000 |
0.31 |
153,754 |
2,000,000 |
|
10 |
500,000 |
0.27 |
134,872 |
2,500,000 |
|
Net Present Value |
$ 108,057.82 |
|||
|
Internal Rate of Return |
15.10% |
|||
|
Payback Period |
5.00 years |
Scenario 2: Initial investment is assumed as $2,600,000
|
Cost of Capital |
14% |
|||
|
Years |
Amount (in $) |
Discounting Factor @14% |
Discounted Cash Flows (in $) |
Cumulative Cash Inflows (in $) |
|
0 |
(2,600,000) |
1 |
(2,600,000) |
(2,600,000) |
|
1 |
500,000 |
0.88 |
438,596 |
(2,100,000) |
|
2 |
500,000 |
0.77 |
384,734 |
(1,600,000) |
|
3 |
500,000 |
0.67 |
337,486 |
(1,100,000) |
|
4 |
500,000 |
0.59 |
296,040 |
(600,000) |
|
5 |
500,000 |
0.52 |
259,684 |
(100,000) |
|
6 |
500,000 |
0.46 |
227,793 |
400,000 |
|
7 |
500,000 |
0.40 |
199,819 |
900,000 |
|
8 |
500,000 |
0.35 |
175,280 |
1,400,000 |
|
9 |
500,000 |
0.31 |
153,754 |
1,900,000 |
|
10 |
500,000 |
0.27 |
134,872 |
2,400,000 |
|
Net Present Value |
$ 8,057.82 |
|||
|
Internal Rate of Return |
14.08% |
|||
|
Payback Period |
5.20 years |
According to the above tables, it could be stated that ECC needs to consider paying $2.5 million. The IRR is exceeding 1% cost of capital and there is minimal room for error. In addition, the payback period is obtained as five years. On the other hand, if the initial outlay is assumed as $2,600,000, then the internal rate of return is almost even with the cost of capital. In addition, the amount of profit would be minimized. Therefore, the maximum amount that ECC could afford to pay for acquiring the supplier would be $2,500,000.
Memo to the President of ECC by showing the effects in relation to cost of capital, expected savings and supplier payment:
To: The President
From: Analyst
CC: Staff members associated with the meeting
Date: 27 May 2017
Subject: Investment analysis
In today’s staff meeting, a discussion has taken place about the benefits and drawbacks of the supplier of ECC in association with the potential investment. After considerable research and analysis, the staffs have concluded that acquiring the supplier would be a feasible investment for the supplier. If ECC undertakes the decision of acquiring the supplier at $2,000,000 with a cost of capital of 14%, the net present value is obtained as positive and the internal rate of return is above 14%. Therefore, acquisition of the supplier would be a beneficial option for the organization. In addition, the payback period is obtained as four years, which is lower than the economic life of the project.
Moreover, if the anticipated savings of the investment is less than $500,000 each year, the least amount of savings that ECC could expect for increasing the attractiveness of the investment is $400,000. The maximum amount that ECC could afford to pay for acquiring the supplier would be $2,500,000 because anything above this amount might reduce the overall profitability for ECC. Hence, ECC needs to consider these factors before undertaking the investment decision.
References:
Andor, G., Mohanty, S. K., & Toth, T. (2015). Capital budgeting practices: a survey of Central and Eastern European firms. Emerging Markets Review, 23, 148-172.
Bierman Jr, H., & Smidt, S. (2014). Advanced capital budgeting: Refinements in the economic analysis of investment projects. Routledge.
Brunzell, T., Liljeblom, E., & Vaihekoski, M. (2013). Determinants of capital budgeting methods and hurdle rates in Nordic firms. Accounting & Finance, 53(1), 85-110.
Burns, R., & Walker, J. (2015). Capital budgeting surveys: the future is now.
Chittenden, F., & Derregia, M. (2015). Uncertainty, irreversibility and the use of ‘rules of thumb’ in capital budgeting. The British Accounting Review, 47(3), 225-236.
Daunfeldt, S. O., & Hartwig, F. (2014). What determines the use of capital budgeting methods? Evidence from Swedish listed companies. Journal of Finance and Economics, 2(4), 101-112.
Dellavigna, S., & Pollet, J. M. (2013). Capital budgeting versus market timing: An evaluation using demographics. The Journal of Finance, 68(1), 237-270.
Hayward, M., Caldwell, A., Steen, J., Gow, D., & Liesch, P. (2017). Entrepreneurs’ Capital Budgeting Orientations and Innovation Outputs: Evidence From Australian Biotechnology Firms. Long Range Planning, 50(2), 121-133.
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