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Investment appraisal – Further aspects of discounted cash flows

Incorporating working capital

Investment in a new project often requires an additional investment in working capital
for the project duration, such as increasing inventory levels or offering credit to
customers (offset by taking credit from suppliers).

There are therefore relevant cash flows related to working capital that need to be
included in the NPV.

The treatment of working capital is as follows:

 Initial investment is a cash outflow at the start of the project

 If the investment is increased, the increase is a relevant cash outflow

 If the investment is decreased, the decrease is a relevant cash inflow

 Working capital is ‘released’ at the end of the project, leading to a cash inflow

Question 9

Working capital

A company expects sales for a new project to be $20,000 in the first year,
growing at 4% per annum. The project is expected to last for 3 years. Working
capital equal to 15% of annual sales is required and needs to be in place at the
start of each year.

Calculate the working capital cash flows for incorporation into the NPV
calculation.

Time t0 t1 t2 t3
Sales $20,000 $20,800 $21,632

Working capital needed $3,000 $3,120 $3,245 $0
Cash flows $(3,000) $(120) $(125) $3,245

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