Investment Opportunity
Introduction
Recently Eddison Electronics Company (EEC) has been approached about purchasing one of their largest suppliers of component parts. The President of the company has called an emergency meeting to discuss this likely purchase. He has requested that the financial analyst team investigate the feasibility of acquiring this supplier, such as what exactly the investment opportunity entails for the company, and how to go about making a decision on whether to invest in this acquirement or not. In order to make a decision regarding this, different techniques of capital budgeting needs to be analyzed so that an accurate decision can be made. Also, my opinion is needed in this decision, so after investigating this matter thoroughly it will be decided as to whether the company should go ahead or not, and why.
Making Investment Decisions
Investment decisions are very important for the growth or failure of the business. Risks are a part of every investment decision and should be looked at thoroughly. In order to make a decision regarding the venture of the supplier purchase the management team will have to directly assess the financial implications of the investment for the business. To do this different evaluation methods will have to be applied to expectant financial data related to the acquisition in which different costs and benefits will be identified. By applying different evaluation methods results can specifically be measured which will be relevant for making an accurate decision regarding the venture. The information that is to be obtained for which a determination can be made regarding the venture will be the inflows that the venture will create during the period of payback for the business; this related information will tell the business the total acquired time it may be before the initial investment is recovered, the value over time for the venture; in relation to this the present and future money for the venture over time for the business will be reflected, and is this venture capable of either meeting or exceeding the capital cost for the business; in this respect the return rate required for the venture will need to be, at the most, met if not exceeded. The businesses’ management team will be more capable of making an accurate investment decision regarding the venture with this information. In addition, if other options are present regarding the investment venture, then they can be measured sufficiently and compared with this information (Haskart, 2010).
Payback Period Evaluation
The payback method is a calculation that will be applied as a means of determining the total duration of time it will take for the business to recuperate initial costs associated with the venture. This will be done by looking at the inflows that the venture will produce throughout the period of payback for the business. The period of payback will be expressed in years, and it will be the total time it will take for the businesses investment venture to recover itself. Although there will be no details on profitability for the business by looking at the period of payback, there will, however be more accuracy given in determining the time length for recovery of the investment by looking at the flows of net cash that is anticipated by the investment for the business. The period of payback estimate is somewhat simple in that the total amount of the venture’s cash flows for each annual period will need to be summed up until the total equals the venture’s initial investment. Although if the return for the venture is expected to vary from year to year then it can be added up to the anticipated return for all succeeding years to arrive at the total cost of the venture. The formula will be: payback period (in years) = initial investment/annual cash flow from investment. For instance, if the venture is going to cost the business $200,000 and the venture is expected to return $40,000 annually, then the period of payback will be calculated as follows: $200,000/40,000 = 5, which will a total of 5 years before the business will recover initial costs for the venture and it will pay for itself. The basic idea behind the payback method in calculating the period of payback is that the more quickly the cost of the venture can be recovered than the more desirable the venture is for the business. However, this method is not solely reliable for a way to evaluate the venture and make decisions regarding the venture since it does not grasp the total money value of the venture over time and after the point of payback time for the venture the total effect of cash flows will not be accounted for (Garrison, Noreen, & Brewer, 2010).
Net Present Value (NPV) Technique
The NPV (Net Present Value) of the venture will be the variation among the summation of cash flows which will be expected from the venture and the amount which was initially invested for the venture. This method of evaluating the venture will be aligned with the goal of enhancing the value of future ownership in taking on the endeavor. By taking price increases and returns for the venture into account the NPV will represent the present value amount of money to the future value of that same dollar amount (Cliff Notes, 2011). With that being said, the NPV will provide a measurement of profitability for the venture by taking into account the value of money over time. The awareness in taking on a venture is that interest rates and price increases will have an influence on the value of money over time and for this reason a discounted rate should be used in calculating the NPV. In order to select an appropriate discounted rate the weighted average cost of capital or the rate of return on an alternative investment should be considered. In this case, the NPV will consist of discounting the annual flows of cash being obtained from the venture and then comparing them to the original venture total to come to a present value figure. If a positive figure comes back for the NPV then this is an indication that the venture’s value will increase for the business by that specific total and the venture should be agreed to, but if the NPV figure comes back negative then this would be an indication that the venture’s value will not increase for the business and should not be accepted, or at least further evaluation should be done. The NPV brings about more wise decisions being made for management in deciding on different investment ventures as the actual value of dollar can be obtained regarding the venture. However, there is some problems present with the NPV in that it presents a venture’s value in a dollar amount which make comparing it to other alternatives more difficult (Baker, 2000).
Internal Rate of Return (IRR) Technique
The IRR (Internal Rate of Return) method will present the business with the rate at which the venture will begin to generate cash flows. This rate will be revealed to measure and compare the profitability of the venture. Using this method the management team will be provided with results which will indicate whether or not the venture will successfully meet the costs of capital associated with the business investing in it. The time value of money will also be considered with the IRR, and it will be expressed as a percentage which will be related to the performance of the venture. The IRR created by the IRR estimate is evaluated against the rate of return that will be required for the venture. The decision as to whether to accept or reject the investment will rely heavily on the ventures ability to at least meet, but preferably exceed, the return rate that is desired for the endeavor. However, the IRR will not consider the financial reinvestment impact that the venture’s inflows of cash will have on the overall value of the investment (Baker, 2000).
Modified Internal Rate of Return (MIRR) Technique
The MIRR (Modified Internal Rate of Return) will work somewhat like the IRR. The only variation is that the MIRR will consist of accounting for the effects of reinvestment as it relates to the cash inflows of the investment. With that being said, the MIRR will more accurately reflect the cost and profitability of the venture for the business than that of the IRR. Using the rate of reinvestment, all flows of cash, except for the initial outflow of cash for the venture, will be estimated by employing the IRR method of return. This is done to present a separate amount of return to be evaluated against the management teams return rate that is needed for the venture. Also, the MIRR will present a more conventional approach to determining the actual performance of the venture which in return will make agreeing to the venture a positive choice. Since the inflows of reinvestment will not change due to the anticipated inflows from the venture, the true value of the venture will not be changed by the MIRR. The method for the MIRR will use both negative and positive rates for the venture, the funding rate for the venture, the net present rate for the venture, and the re-investment rate for the venture. By measuring the venture with the MIRR the business will be able to identify unsatisfactory investments, in which reinvestment rates and money constraints may limit the assumed calculations of the IRR and NPV. Also, the MIRR measurement will present a single clarification on an investment whereas an IRR measurement may have multiple clarifications on an investment (Stratton, n.d.).
Different Techniques
The different techniques discussed for evaluating an investment will serve the business separately with relevant results to assist in sensibly selecting ventures for the organization to take on. The ventures selected should not only bring value to the organization, but they should also meet the requirements of the businesses shareholders. To further enhance the decision-making process for the management team of the business, the measurable results obtained from these methods should be communicated to all parties concerned and compared with additional investment options of the business. Thus, each method discussed will focus on a developing performance item and, therefore each one should be used in combination with the other to appraise and conclude on whether to make an investment choice. Also, when using each method with the other the managers will be given relevant data on the impact of taking on or declining an investment, and this in return this will allow a more complete view to be given in understanding which venture will make the business a success and which will not (Stratton, n.d.).
Conclusion
By understanding how to calculate the payback period, NPV, IRR, and MIRR better judgments can be made to determine the longevity and success of an investment for the business. Determining the payback period for the venture will allow the business to know to initial costs of the investment and how long it will take to recover costs associated with it. The NPV will represent the exact amount the investment will be worth to the business. The IRR will be of value to the business for determining the rate of return in which profitability for the venture will be met. However, the MIRR will be very useful to the business since it will include more accurate data pertaining to the safekeeping and profitability of the investment. In my opinion, if the investment payback period is not greater than three years, the NPV is positive, and the IRR and MIRR are suitable for the required rate of return then the business venture should be taken on. After all, potential investments are what will keep the business functioning and ensure success for the entire organization.
References
Baker, S. (2000). Perils of the internal rate of return. Retrieved from http://hadm.sph.sc.edu/courses/econ/invest/invest.html
Cliff Notes. (2011). Present value and investment decisions. Retrieved from http://www.cliffsnotes.com/study_guide/Present-Value-and-Investment-Decisions.topicArticleId-9789,articleId-9788.html
Garrison, R., Noreen, E., & Brewer, P. (2010). Managerial accounting, (13th ed.). New York, NY: McGraw-Hill Irwin.
Haskart, B. (2010). Financial analysis: Analyze the market & invest right way for maximized profit. Retrieved from http://www.bukisa.com/articles/419939_financial-analysis-analyzing-the-market-invest-right-way-for-maximized-profit
Stratton, A. (n.d.). Know the modified rate of return MIRR of your investment. Retrieved from http://ezinearticles.com/?Know-The-Modified-Rate-Of-Return-MIRR-Of-Your-Investment&id=681777