Hi guys,
There is one thing related to the working capital investment. Why is this included into the intial investment outlay? Shouldn’t we include this into the cash operating expense? Even assuming that I build an inventory in up front, at time 0, in order to conduct sells, why would this investment reverse in the terminal year? If I sold of all my produced hot dogs, there will be no meat on the inventory which I can sell in order to refund my initial outlay.
Thanks
Investment in WC (increase) is like an interest-free loan.
WC = Current Assets - Current Liabilities
If you buy more inventory (in the initial year, for e.g.), current assets go up. Means your WC goes up because you’re paying for that inventory. When you sell inventory, your current assets go down… you’re recouping your initial year investment. In the terminal year, you have sold all the inventory associated with that project, so your assets go back to the initial level.
Almost all the examples in the book indicate that the investment in WC is made in the initial year and all of that investment is recouped at the end of the project. However, this doesn’t have to be the case. Your WC can go up or down, and usually does, during the life of a normal project.
Thanks Aether.
What still makes me wonder is where does this cash come to rebuild inventory yearly? Considering that the project is self fullfilling and I don’t have to feed it with an additional cash, there are only Sales to provide me with the cash and Current expense to consume that cash. Thus, this inventory investment should be accounted in Sales or Expenses.
Well, there are multiple ways… not a complete list, but cash comes from debt issuance, seasoned equiy offering, extending A/P (hence the indication of an “interest-free loan” in my original post), bank line of credit, retained earnings, etc.
Still don’t get it 
WCInv is the difference between non-cash current assets and non-cash current liabilities. Consider that I buy a printer. That is my FCInv. In order for the printer to work, I need to buy some ink every year (that represents an inventory), which is WCInv. There are two options on how I could buy that ink: take a loan or buy for cash. If I by for cash that represents cash outflow. Even if I buy it for credit, at some point I would have to refund that loan. These cash outflows are not considered in the yearly outflows formula, cause there we have Annual Cash Inflows= Sales - Expenses(administrative + commercial+…) *(1-T) + D*T. Where do my cash expenses for the inventory go?
Well, you answered your own question… in a way :). When you’re doing yearly CF projects, those cash flows include inflows and outflows. The examples in the book stick to conventional cash flows (a negative outflow, followed by positive inflows). However, this doesn’t have to be the case in real life. I think the text really focuses on project decisions as opposed to “what are the accounting entries?”
You’re over-engineering! If you really want to get into the nitty gritty details, look at table 30 in reading 25 (corp fin). That example actually shows you yearly fixed and variable expenses. And then it digs into the statement of cash flows for debt and equity.
Pick a specific example from the text that you’re confused about, and we can take it further…
Ok, I think now it’s good. In the basic formula there are two much assumptions, like I put some cash apart in order to purchase the same inventory up front and cover all current expenses for the same amount of cash on a early basis. In the terminal year I get back this cash. Every year this fixed cash expense is mentioned as Expenses in the formula.
Thanks Aether