Calculation of operating cash flow after tax

CFA Level II
#1

In practice test England (Corporate Finance) and question number 1 we are supposed to calculate the after tax operating cash. The answer is 0,81. In the table additional net working capital is listed as 0,43 and my question is why is not this deducted so that the after tax operating cash flow is 0,38 which is also one of the answer alternatives? This is the formula:

Annual after-tax operating cash flow: CF = (S – C – D)(1 – T) + D

Why do we not deduct working capital from this amount, as it is a part of the operating cash flow?

#2

Operating expenditures related to WC are in OCF marked with letter C. Investments in WC are contained in Inital Outflow outlay and are not in OCF. Consider it as a project which have its beginning starting with investments into FC and WC, incremental CFs (OCFs) and end (TNOCF).

#3

Like flashback pointed out, working capital is part of initial outlay and terminal cash flow, thus has nothing to do with operating cash flow.

#4

Yes I agree. However in this exercise, the working capital also increased every year. So per definition the real cash flow was lower than if not deducting working capital. I would agree with you guys if it was only an initial outlay though.

#5

Flashback is right.

Basically an increase in working capital, not an investment in working capital, would be a reduction of cost. In the formula you’re trying to use, (S-C-D), a decrease in cost would be -(-C) so you’d be adding in this instance. Think about it, reducing cost essentially means more after tax cash.

#6

Ok. But still, in the exercise, the net increase in WC every year, is ignored in the solution. It is not only an initial outlay.

#7

There is no question asking you about total cash flows, but it doesn’t mean that WC is ignored in the solutions.

Question 1 is only about operating cash flows, not total cash flows.

#8

Yes and working capital is a part of operating cash flow, not financing or investing.

#9

True for financial reporting

But not under a ‘corporate finance’ perspective, where operating cash flows are limited to what you mentionned in your initial post. I understand WC as an extra investment outlay that is needed for the project.

#10

An extra investement outlay (as part of WCInv as well as FCInv) may be taken to improve further OCFs.

Consider purchasing a machine or supply chain efficiency improvement (f.ex. due to changes in new technology) just to reduce operating costs and imoprove long term further operating process efficiency. Also this action could be taken at the exact moment when is f.ex. interest and tax enivironment is favorable.

#11

is the working capital expenditure being incurred in every year after the initial outlay?

#12

Keep in Mind the definition of OCF.

It has already subtracted WCInv.

If you look at the FCFE calculation equation modifications, you could find this difference there. The ones which uses CFO to arrive at FCFE/FCFF vs the ones which uses NI to arrive at FCFF/FCFE.

As per your question, if the yearly OCFs are given then it should already take into account the reduction in OCF due to incremenets in WCInv.

So i guess, this whole question was thrown at the reader to confuse him/her with excess information

I hope that helps.