Working Capital Effect
Working capital constitutes another important ingredient of the cash flow stream which is directly related to an investment proposal. The term working capital is used here in net sense, that is, current assets minus current liabilities (net working capital). If an investment is expected to increase sales it is likely that there will be an-increase in current assets in the form of accounts receivable, inventory ‘and cash, But .part of this increase in current assets will be offset by an increase in current liabilities in the form of increased accounts and notes payable. Obviously, the sum ‘equivalent to the difference between these additional current assets and’ current liabilities will be needed-to carry out the investment proposal. Sometimes, it may constitute a significant part of the total investment in a project. The increased working .capital fonn part of the initial cash outlay. The additional net working capital will however be returned to the firm at the end of the project’s life-Therefore the recovery of working capital becomes part of the cash inflow stream in the terminal year. The initial investment in, and the subsequent recovery of, working capital do not balance out each other due to the time value of money. The increase in the working capital may not only be in the zero time period, ‘that is, at the time of’initial investment. There can be continuous increase in the working capital as sales increase in later years. This increase in’ working capital should be considered as cash outflow of the year in which additional working capital is required Suppose there is a project that requires an initial investment of Rs ‘20,000 and has a useful life of 5 years. The requirements of working capital are detailed in Table 10.5
Working capital Requirement
The changes in the net working capital are given in me last row of Table 10.5. 1he net working capital has increased in years I, 2 and 3 representing cash outflows, while ii has decreased i’l years 4 and 5 showing cash inflows as working capital is recovered Almost all revenue-expansion capital investment proposals require additional working capital. Likewise, almost all cost reduction capital investment projects release the existing ‘amount of working capital, Such projects enhance the firm’s efficiency in such a way mat me amount of inventory ‘on hand or accounts receivable can be reduced. Improved inventory control systems or improved billing and collection systems are some classic examples. From me point of view of evaluating an investment project, the amount of working capital so released should be seen as a cash inflow iit me zero time period (when the investment proposal is being considered), reducing the net cash investment’ required for the project. In me terminating year of. the project it should be treated as a cash outflow and adjusted against the cash inflow of mat year.