F9 WORKING CAPITAL Ali Sattar’s

Working capital IMPLICATIONS

Almost every investment in fixed assets also requires an additional investment in current assets or
working capital. This is a favorite 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 0 1 2 3

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: £300
years 2: £500
years 3: £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 £60 £(60)
1 £100 £(40)
2 £80 £20
3 nill £80

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

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F9 WORKING CAPITAL Ali Sattar’s

0 1 2 3
Expenditures £(1000)
Scrap value £200
Working capital £(60) £(40) £20 £80
Net revenues £300 £500 £400
------------ ----------- ------------ ------------
Net cash flows £(1060) £240 £520 £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

For example; 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 £300 £(300)
1 £300 x (=1+0.10)1 = £330 £(30)
2 £300 x (=1+0.10)2 = £363 £(33)
3 nill £363

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

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 £300
year 2 £500
year 3 £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 year’s net revenue. Inflation is 10 %

Years working capital working capital working capital

Requirements Requirements cash flow
(Real times) (Money terms) (Money terms)
0 £60 £60 £(60)
1
1 £100 £100x(1.10) = £110 £(50)
2 £80 £80x(1.10) 2 = £97 £13
3 nill nill £97

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

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