Hi, I am having trouble trying to understand the logic behind NPV calculation involving changes to net working capital (NWC). Since NPV calculation ignores interest expense, I don’t understand how the following scenarios could have different NPV. Case 1: Inv is increased by 1000. Current liability remains the same. Therefore change in NWC = 1000. So initial cash outflow is increased by 1000. Case 2: Inv is increased by 1000, but the company owes the amount to the supplier (with interest). In this case, CA is increased by 1000 and CL is increased by 1000. Therefore change in NWC = 0. So initial cash flow is not increased. Comparing case 1 and 2, because case 1 involves a higher net cash ouflow at the beginning of the project, it would have a lower NPV. I am not sure if case 1 is worse though, because when the company pays back the interest (in case 2), it seems like both cases should have the same NPV. Thanks in advance.
In both scenarios, the $1000 cash paid for the inventory is occurring in different periods. NPV cannot be the same.
That is what is bothering me. Since we use NPV to decide which project to take, from my examples above, case 2 looks more attractive (ie. it is better if we borrow the money required to finance the increase in inventory). But I am not convinced that case 2 should have a higher NPV, because when the interest is finally paid back, that would reduce the company’s value.
if you are talking fcff from equity section - interest cost impact does not matter. if you talking in terms of corp fin cash flows for Capital budgeting, too, interest costs are not a part of cash flow computations. They are included in the discount rate - since you use WACC. So the fact that you are buying WC on debt - would get figured into a higher discount rate, so your value will fall, as a result. Your other implicit assumption seems to be that both projects would be discounted at the same rate. But if they are different risk projects - they would not be… they would have project betas different from the company’s beta. does this make sense?
cpk, thanks for the explanation. I was referring to the capital budgeting case. Your logic indeed makes sense. I did take take into account the fact that WACC would go up if AR goes up.