The NPV consists of the initial capital invested in the Knyttan unit and is essential in the determination of the current value of all future cash flows that the unit generates. Thus, in capital budgeting, it becomes a vital tool in the establishment of whether a project is viable and determination of the project with the greatest profitability (Bora, 2015). At an interest rate of 8%, the project has a net present value of $21,093 and -$115,908 when the interest rates increase to 18%. Thus, when interest rates increase, the project becomes undesirable. Therefore, the project is a worthwhile investment at 8% interest rates.
The Internal Rate of Return (IRR)
The metric is used to provide the return rate of a specific project accurately in comparison to its cost of investment. Furthermore, it uses a deduction ratio that causes the NPV of the whole project cash flow to be equivalent to nil balances (Bora, 2015). Thus, for the Knyttan project, at 8% interest rates, the IRR is 30%, and when the interest rates increase to 18%, the value of IRR drops to 20%. Therefore, the project is more desirable at 8% interest rates as the value of the IRR is higher in comparison to when the interest rates are at 18%.
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Payback Method
This accounting technique is used in the assessment of the time duration before a project recuperates its sum invested. The metric consists of simple computations that deduct each projection of cash from the initial outflow of cash until the payback period are attained (Bora, 2015). From the computed values at 8% interest rates, the period of payback is three years and two months. When the interest rates are increased to 18%, the payback period reduces by two months, and the cost of investment is recovered within three years.
In general, the project is more desirable at 8% interest rate as it has a higher net present value of $21,093 and an internal rate of 30%. However, at this interest rate payback period is longer by two months. Therefore, the project is viable at the rate of 8% interest, but risk increases when the interest rates inflate.
Role of Net Working Capital, Depreciation, and Taxation
In the computation the Knyttan unit's cash flows, the net working capital has a great impact on the overall operating cash flow. This is because the computation of the networking income involves the division of the existing assets by the present liabilities. Hence, this liquidity ratio determines how a company can use its short term assets in offsetting the present liabilities (Grant, 2016). When the business fails to clear its short term obligations using the assets that can easily be converted to cash, then the company will be forced to use its long-term assets. If such a situation is experienced, then the company will experience a reduced cash flow as its operations and sales will decrease.
Depreciation, is on the other hand, equally significant as it is a non-cash expense and has no effect on the cash flows. Thus depreciation has no direct association with the cash flow as the valve that is deducted from the financial accounts is at the end added back as the real amount never left the bank. But the rate of depreciation together with amortization is deductible to obtain the profit before taxation (Abor, 2017). This is an indication that when the depreciation value is great, then the3 taxable profit will be low and consequently the amount of money paid as tax is equally low. Therefore, there is a correlation between taxation, depreciation, and the cash flow as the fluctuations in depreciation reflects on the taxes paid and which in turn dictate the tax savings for the company.
References
Abor, J. Y. (2017). Evaluating Capital Investment Decisions: Capital Budgeting. In Entrepreneurial Finance for MSMEs (pp. 293-320). Palgrave Macmillan, Cham.
Bora, B. (2015). Comparison between net present value and internal rate of return. International journal of research in finance and marketing, 5(12), 61-71.
Grant, R. M. (2016). Contemporary strategy analysis: Text and cases edition. Hoboken, NJ: John Wiley & Sons.
