Investments are important aspects of a business that require the managers to determine the most profitable or viable investment for the business. A manager can determine the financial viability and profitability of a project or investment using methods like capital budgeting. Capital budgeting methods include net present value, internal rate of return, and payback period (Horngren, Harrison, & Oliver, 2015) . These methods use different techniques to determine the viability of a long-term investment thereby help in the decision-making process of the firm. Applying these techniques to the technology acquisition project at Jon Smedley, we determine the acceptability of the project.
Capital Budgeting Techniques
Jon Smedley is looking to invest in Knyttan technology to help produce bespoke goods and also increase market share. The cost of this technology is $197,445 with an expected interest rate of 8% and 18%. The acceptability of the project is based on the net present value, internal rate of return, and payback period at the expected interest rates of 8% and 18%.
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Net present value (NPV) is a discounted method that determines the difference between the present value of the cash inflows and of the cash outflows over a certain period (Wang & Zhou, 2016) . Over seven years, the NPV of the Knyttan project is $21,093 at 8% rate and -$115,908 at 18% rate. The project is acceptable at an interest rate of 8% because the NPV is positive. This means that the cash inflows will exceed the cash outflows after the seven years hence the firm will make a profit.
The internal rate of return (IRR) is used to determine the profitability of a potential investment (Sharan, 2015) . The IRR is the discount rate that equates the NPV of all project cash flows to zero. Based on the calculations, the IRR of the Knyttan project is 30% when the cost of capital is 8% and 20% when the cost of capital is 18%. Both IRRs are acceptable because they exceed the project’s estimated cost of capital (8% and 18%). However, the 30% IRR is more acceptable because the higher the difference between the two discount rates, the higher the net cash flow to the investor.
The payback period is the length of time that investments take to recover the initial outlay (Steiner, 2012) . Based on the calculations, the payback period when the project’s cost of capital is 8% is 3.2 years and 3 years when the cost of capital is 18%. Usually, the shortest period is most acceptable but in this project 3.2-year period is most acceptable because the firm makes a profit in the end unlike the 3-year period yet the NPV and IRR are not suitable.
Conclusion
The project is most viable when the firm applies the 8% discount rate. When calculating the operating cash flows of a project, the net working capital, depreciation, and taxation are important factors. The net working capital is the difference between a firm’s current assets and its current liabilities. The NWC will affect cash flow because any changes in line items of working capital will increase or decrease cash flow. Depreciation and taxation are expenses that are deducted from a project’s cash flow for each period.
References
Horngren, C., Harrison, W., & Oliver, S. (2015). Financial Accounting (7th ed.). Melbourne: Pearson Australia Pty Ltd.
Sharan, V. (2015). Fundamentals of Financial Management. Mumbai: Pearson Education India.
Steiner, B. (2012). Mastering Financial Calculations: A Step-by-Step Guide to the Mathematics of Financial Market Instruments. Harlow: Pearson.
Wang, D., & Zhou, F. (2016). The Application of Financial Analysis in Business Management. Open Journal of Business and Management, 4 , 471-475.
