Change in Working Capital Working capital consists of short-term assets, also referred to as current
Change in Working Capital Working capital consists of short-term assets, also referred to as current
assets, that support the day-to-day operating activity of the business. Net working capital is the difference between current assets and current liabilities. Net working capital is what would be left over if the firm had to pay off its current obligations using its current assets.
The adjustment we make for changes in net working capital is attributable to two sources:
1. A change in current asset accounts for transactions or precautionary needs; and
2. The use of the accrual method of accounting. An investment may increase the firm’s level of operations, resulting
in an increase in the net working capital needed. If the investment is to produce a new product, the firm may have to invest more in inventory (raw materials, work-in-process, and finished goods). If increasing sales means extending more credit, then the firm’s accounts receivable will increase. If the investment requires maintaining a higher cash balance to handle the increased level of transactions, the firm will need more cash. If the investment makes the firm’s production facilities more efficient, it may be able to reduce the level of inventory.
Capital Budgeting: Cash Flows
Because of an increase in the level of transactions, the firm may want to keep more cash and inventory on hand. As the level of opera- tions increase, the effect of any fluctuations in demand for goods and services may increase, requiring the firm to keep additional cash and inventory “just in case.” The firm may also increase working capital as
a precaution because if there is greater variability of cash and inventory,
a greater safety cushion will be needed. On the other hand, if a project enables the firm to be more efficient or lowers costs, it may lower its investment in cash, marketable securities, or inventory, releasing funds for investment elsewhere.
We also use the change in working capital to adjust accounting income (revenues less expenses) to a cash basis because cash flow is ulti- mately what we are valuing, not accounting numbers. But since we gen- erally have only the accounting numbers to work from, we use this information, making adjustments to arrive at cash.
To see how this works, let’s look at the cash flow from sales. Not every dollar of sales is collected in the year of sale: Some customers may pay later. This means that the annual sales figure does not represent the cash inflow from sales, because some of these sales are collected in the next period. This also means that at the end of the year, there will be some accounts receivable from customers who have not paid yet.
For example, suppose you expect sales in the first year to increase by $20,000 per month and customers typically take 30 days to pay. The change in cash flow from sales in the first year is not $20,000 × 12 = $240,000, but rather $20,000 × 11 = $220,000 because one month’s worth of sales has not been collected in cash by the end of the year. You adjust for the difference between what is sold and what is collected in cash by keeping track of the change in working capital, which in this case is the increase in accounts receivable, as shown below:
Change in revenues
Less: increase in accounts receivable 20,000 Change in cash inflow from sales
On the other side of the balance sheet, if the firm increases its pur- chases of raw materials and incurs higher production costs, such as labor, the firm may increase its level of short-term liabilities, such as accounts payable and salary and wages payable. Suppose expenses for materials and supplies are forecasted at $10,000 per month for the first year and it takes the firm 30 days to pay. Expenses for the first year are $10,000 × 12 = $120,000, yet cash outflow for these expenses is only $10,000 × 11 = $110,000. Accounts payable increases by $10,000, rep- resenting one month’s of expenses. The increase in net working capital
LONG-TERM INVESTMENT DECISIONS
(increase in accounts payable ⇒ increases current liabilities ⇒ decreases net working capital) reduces the cost of goods sold to give us the cash outflow from expenses:
Cost of goods sold
Less: increase in accounts payable 10,000 Change in cash flow for expenses $110,000
A new project may have one of three effects on working capital: an increase, a decrease, or no change. Furthermore, working capital may change at the beginning of the project or at any point during the life of the project. For example, as a new product is introduced, sales may be terrific in the first few years, requiring an increase in cash, accounts receivable, and inventory to support these increased sales. But all of this requires an increase in working capital—a cash outflow.
But later sales may fall off as competitors enter the market. As sales and production fall off, the need for the increased cash, accounts receiv- able, and inventory also falls off. As cash, accounts receivable, and inventory are reduced, there is a cash inflow in the form of the reduction in the funds that become available for other uses within the firm.
A change in net working capital can be thought of as part of the ini- tial investment—the amount necessary to get the project going. Or it can be considered generally as part of operating activity—the day-to- day business of the firm. So where do we classify the cash flow associ- ated with net working capital? With the asset acquisition and disposi- tion represented in the new project, or with the operating cash flows?
If a project requires a change in the firm’s net working capital accounts that persists for the duration of the project—say, an increase in inventory levels starting at the time of the investment—we tend to clas- sify the change as part of the acquisition costs at the beginning of the project and as part of disposition proceeds at the end of project. If, on the other hand, the change in net working capital is due to the fact that accrual accounting does not coincide with cash flows, we tend to clas- sify the change as part of the operating cash flows.
In many applications, however, we can arbitrarily classify the change in working capital as either investment cash flows or operating cash flows. And the classification doesn’t really matter since it’s the bottom line—the change in net cash flows—that matter. How we classify the change in working capital doesn’t affect a project’s attractiveness. For purposes of illustrating the calculation of cash flows, we will assume that changes in working capital occur only at the beginning and the end of the project’s life. Therefore, changes in working capital will be classified along with acquisition and disposition cash flows in the examples in this chapter.
Capital Budgeting: Cash Flows
EXHIBIT 12.2 An Example of the Calculation of the Change in Operating Cash
Flow
Change in sales
$200,000 Less: change in expenses
150,000 Less: change in depreciation
10,000 Change in Taxable Income
Change in taxable income $40,000
Adjust for the change in taxes
Less taxes
16,000 Change in income after taxes
Add back noncash expenses such as Add: depreciation 10,000 depreciation
Change in Operating Cash Flow Change in operating cash flow $34,000
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
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