Applied Managerial Accounting ACCT614 Unit 3

Advantages and disadvantages of investing methods

Advantages of NPV

The obvious advantage of this method is that it considers the time value of money; a dollar today is worth more than a dollar in the future. NPV discounts cash flows for different periods. The NPV also tells investors whether an investment will create value for them and by how much in terms of dollars. Finally, the NPV considers the cost of capital as well as risk inherent when projected about the future. Generally, the projection of cash flows five years into the future is inherently less than cash flows projected over four years of less (Hopkinson, 2017).

Disadvantages of NPV

This investing method requires some guesswork regarding the company’s cost of capital, which can give misleading results (Hopkinson, 2017). For instance, investors may forego too many investments if the cost of capital is too high. Additionally, NPV is not useful in comparing two projects that differ in size. In most instances, the size of the NPV is determined mostly by the size of the input.

Advantages of Payback period

The payback period is easy to understand and simple to use. It is relatively easier to calculate because it needs very few inputs (Abor, 2017). Another advantage of this method is the preference for liquidity. In most cases, a project with a shorter payback period is usually less risky. This investing method is also useful in case of uncertainty; thus, reducing the chances of loss through obsolescence.

Disadvantages of Payback period

One of the disadvantages of this method is that it ignores the time value of money, which is very crucial in the business concept (Abor, 2017). Another disadvantage of this investing method is that not all cash flows are covered; it fails to consider cash flows that come in subsequent years. Payback period also ignores profitability; a project with a shorter payback period does not guarantee that it will be profitable.

Advantages of IRR

One of the advantages of this investing method is that it provides the exact rate of return for a project as compared to the cost of the investment. The IRR thus allows investors to get a sneak peek into potential returns that a project can generate. Lastly, IRR considers the time value of money.

Disadvantages of IRR

This investing method does not consider important factors such as the size of a project, future costs, and project duration (Abor, 2017). The IRR only compares cash flows of a project to the existing costs of a project, excluding the factors above.

Investing method to be used by EEC

It is advisable for EEC to use the NPV method. One of the major reasons for recommending this method is that it takes into account the time value of money. Also, this investing method allows risk factors to enter into the calculation (Hopkinson, 2017). Considering these risks when making future projections ensure that accurate findings are made. Therefore, EEC should use this method when making investment decisions.

Increasing cost of capital to 25%

Assume r = 25%

NPV = {500,000 * [(1 – (1.25)^-10] / 0.25} – 2,000,000

=1,785,252 – 2,000,000

= -$214,748

My answer will not be the same if the cost of capital is increased to 25% because it leads to a negative NPV. According to NPV decision rule, an investment with positive NPV should be accepted, while that with a negative NPV should be rejected because a project with a negative NPV is likely to result in a net loss.

Failure to save $500,000 as anticipated

Also, my answer would not be the same if EEC fails to save the anticipated amount of money. This is because if it does show, it means that there would be no cash inflows; thus, leading to negative NPV. As mentioned earlier, a project with a negative NPV will result in net loss; hence, it should be rejected.

Least amount of saving that would make the investment attractive to EEC.

This amount would equate NPV to zero.

NPV = C * [(1-(1 + i)^-n] / i} – 2,000,000

0 = C * [(1 – (1.14)^-10] / 0.14

2,000,000 = C * [(1 – (1.14)^-10] / 0.14

2,000,000 = 5.216C

C = $383,436

The least amount of saving for the investment to be attractive to EEC should be $383,436

Decision based on calculations

NPV

PV of annuity = C * [(1-(1 + i)^-n] / i

= 500,000 * [(1 – (1.14)^-10] / 0.14

= 2,608,058

NPV = PV of inflows – PV of outflows

= 2,608,058 – 2,000,000

= $608,058

Payback Period

Payback period is 4 years

Internal Rate of Return (IRR)

IRR equates NPV to zero

Assume r = 12%

NPV = 500,000 * [(1 – (1.12)^-10] / 0.12

= 2,825,000 – 2,000,000

=825,000

Assume r = 18%

NPV = 500,000 * [(1 – (1.18)^-10] / 0.18

=2,696,452 – 2,000,000

=696,452

Assume r = 20.9%

NPV = {500,000 * [(1 – (1.209)^-10] / 0.209} – 2,000,000

=33,785

Assume r = 21%

NPV = 500,000 * [(1 – (1.21)^-10] / 0.21

=27,039

Assume r = 21.2%

NPV = {500,000 * [(1 – (1.212)^-10] / 0.212} – 2,000,000

=13,500

Assumer r = 21.4

NPV = 500,000 * [(1 – (1.214)^-10] / 0.214

= 0

Therefore, IRR = 21.4%

Based on the calculations above, EEC should acquire the supplier. One of the reasons is that it has a positive NPV, which indicates that the acquisition would be profitable. Another reason is that it has a short payback period. Lastly, the IRR is higher that the required rate of return, which reveals that the acquisition will be profitable.

References

Abor, J. Y. (2017). Evaluating Capital Investment Decisions: Capital Budgeting. In Entrepreneurial Finance for MSMEs (pp. 293-320). Palgrave Macmillan, Cham.

Hopkinson, M. (2017). Net Present value and risk modeling for projects. Routledge.