NET WORKING CAPITAL AND CASH FLOWS

The following example is designed to shed some light on the correct handling of net working capital cash flows in project valuation, i.e., NPV analysis. You are the proprietor of a mythical firm that has a two day life. You sell !eer on the !each. You hire la!or for "#$ per day. You want "%$$$ in inventory at the !eginning of each day and to sell your entire inventory daily. You prefer to stock out of inventory rather than providing storage overnight. Your inventory must !e paid for in cash at delivery at the start of each day. You have a %$$& mark up. 't the start of the first day, t($, you pay for your first "%$$$ in inventory. This sum represents your net working capital outlay at t($ )note* no current lia!ilities are created to fund this increase in inventory, e.g., no accounts paya!le+. The end of day % and the !eginning of day two are !oth la!eled t(%. The end of day two is t(,. Your daily income statements are as follows* -ay % .ales /0. 01 2a!or 34T Tax )#$&+ 3'T ",$$$ %$$$ "%$$$ #$ "5#$ 67# "67# "5#$ 67# "67# -ay , ",$$$ %$$$ "%$$$ #$

Your daily cash flow pattern looks as follows* t=0 t=1 t=2 88888888888888888888888888888888888888888888888888888888888888888888888888888 8 Cash Inflows ",$$$ )/ash .ales+ ",$$$ )/ash .ales+ Cash D!s"#$s%&%nts "%$$$ )9nv+ "%$$$ )9nv+ #$ ):ages+ #$ ):ages+ 67# )Tax+ 67# )Tax+
1

8888888 N%t Cash

888888

888888 '(1000) (*+, (1*+,

Flow

Your daily net working capital cash flow pattern is as follows* N%t W-C O#t N%t W-C In

t=0 t=1 t=2 888888888888888888888888888888888888888888 N%t Wo$.!n/ Ca0!tal Cash Flow 'NWC) 't time t($ we invested in Net :orking /apital in the amount of "%,$$$. 't t(, we recapture this investment in Net :orking /apital as our inventory is changed from "%,$$$ at time t(% to "$ at time t(,. Note that if we now com!ine the income statements and the negative of the changes in Net :orking /apital we can recreate the actual cash flow pattern for times t($, t(%, and t(,. The a!ove example extrapolates to the general procedure that we will follow of <flowing out= the net working capital for a project at t($ and <flowing in= the investment in net working capital at the conclusion of the projects life, in this case t(,. This will make more sense later in the class. 9t is important to introduce it now when we first start to talk a!out finding >/> so we don?t create early confusions. Note, however, that if we could charge the inventory for one day, i.e., create an accounts paya!le for one day, the cash flow picture would drastically change. The effective net working capital would !e @ero, i.e., current assets, or inventory, would eAual current lia!ilities, or accounts paya!le. Therefore, the net cash flows would !e "67# at !oth t(% and t(, with no cash flow at t($. :hat would !e the net cash flow !y period if we could charge one half of the inventory for each time periodB )'s a check, your answer should !e as follows* t($ ( "#$$C t(%( "67#, t(,( "57#.+ 1y experience indicates that the correct handling of net working capital cash flows for project or firm valuation is a significant mystery for students. Please see me if this example does not clear up the pu@@le for youD ;"%$$$ $ "%$$$