In capital budgeting when determining the terminal cash flow of a project. In case there was a new inventory that was injected in Y=2 to boost sales, why do we add it back in calculating the terminal cash flow?
The question will tell you if the working capital can be recovered at the terminal year. If so, then recover it.
When you operate a new equipment or introduce a new project, you may be required to increase working capital such as inventory or other things. Sometimes the working capital changes occurring in multiple years and not just initial year. At the closing of the project, maybe you can sell off those inventory items or other means, so you would reverse that at terminal year.
Not all problems will say the working capital is reversed at terminal year.
This is quiet helpful, thanks!
But still I have a question, since working capital goes into operations, it will be reflected in sales and COGS. Why would I still recover it even if the question says so, did not it go into operations. Or is when the project is ending at the terminal cashflow, you will sell the ending inventory you have and in that sense it is recovered?
One example is additional inventory you need to carry for the project. In the last period, you sell the inventory and get the cash back.
Think of it like a change in the required normal level of working capital to support operations with the new project. Like additional inventory needed, or additional receivables due to the extra sales. If the project ends, this extra wc is no longer needed, so you sell the additional inventory or you collect all receivables from the project and don’t get new ones (as there are no more associated new sales), and thus you have a cash inflow before returning to the old wc level.