F9

WORKING CAPITAL

Ali Sattars

Working capital IMPLICATIONS

Almost every investment in fixed assets also requires an additional investment in
current assets or working capital. This is a favourite complication of the examiner's
There are four potential exam scenarios which we can illustrate as follows;
1. The most straightforward situation is where there is a single investment
required in working capital at Year 0 in a question that does not involve
inflation. In the case, what you need to remember is that we always assume
full recovery of working capital at the end of the project's life
For example; a project costs 1000, it has 3 year life and scrap value of 500. It will
produce annual net revenues of 600 and requires an investment of 200 in working
capital the net cash flows;
Years

Capital
(1,000)
Scrap value
500
Working capital (200)
200
Net revenues
600
600
600
----------- ------------ ------------ ----------Net cash flow (1,200)
600
600
1,300
2. The next situation is where the level of investment in working capital varies
with the level of business activity, still within a situation with no inflation
For example; a project costs 1000 and has a scrap value of 200 at the end of its 3
year life the annual net revenues are as follows;
years 1:
years 2:
years 3:

300
500
400

At the start of each year the project will require working capital equal to 20% of thats
year's net revenues
For example:
Years
working capital
working capital
requirment
cash flow
0
1
2
3

60
100
80
nill

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(60)
(40)
20
80
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F9

WORKING CAPITAL

Ali Sattars

This NPV analysis is concerned what is needed is not the working capital requirement,
but the working capital cash flow and so:
0

Expenditures
(1000)
Scrap value
Working capital
(60)
(40)
Net revenues
300
---------------------Net cash flows
(1060)
240

3
200
20
500
-----------520

80
400
-----------580

Once again notice the full recovery of working capital:

60 + 40

= 100 expenditure and 20 + 80 + 100 recovery

3. The third situation repeats the first example, but now with the additional
complication of inflation
A project costs 1000 and has 3 years life, at the end of which time it has a residual
value of 200. It produces net revenues of 500 in today's price. The proceeds an
investment of 300 in working capital, in today's price inflation is 10% per year
The investment in working capital is continually "turned over (as stock up and replaced,
etc ) the amount of money invested in working capital case
Line with the rate of inflation
Years
working capital
working capital
requirment
cash flow
0
1
2
3

300
300 x (=1+0.10)1 = 330
300 x (=1+0.10)2 = 363
nill

(300)
(30)
(33)
363

Once again notice, total expenditure = 363 and total recovery = 363

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F9

WORKING CAPITAL

Ali Sattars

4. The fourth situation is similar to the second example, but also with the addition of
inflation
For example; a project costs 1000 it has a 3 years life and scrap value of 200 it
produces net revenues of
year 1
year 2
year 3

300
500
400

All the above data is in current terms. At the start of each year the project requires
working capital equal to 20% of that years net revenue. Inflation is 10 %
Years
0
1
2
3

working capital
working capital
working capital
Requirements
Requirements
cash flow
(Real times)
(Money terms)
(Money terms)
60
60
(60)
1
100
100x(1.10) = 110
(50)
80
80x(1.10)2 = 97
13
nill
nill
97

A FINAL POINT: note that working capital expenditure has no impact on the company's
tax liabilities, in any circumstances.

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