11.4 The Capitol Rationing Process

Investments in working capital

An investment in a capital asset usually must be supported by an investment in working capital, such as accounts receivable and inventory. For example, companies often invest in a capital project expecting to increase sales. Increased sales usually bring about an increase in accounts receivable from customers and an increase in inventory to support the higher sales level. The increases in current assets—accounts receivable and inventory—are investments in working capital that usually are recovered in full at the end of a capital project’s life. Such working capital investments should be considered in capital-budgeting decisions.

To illustrate, assume that a company is considering a capital project involving a $50,000 investment in machinery and a $40,000 investment in working capital. The machine, which will produce a new product, has an estimated useful life of eight years and no salvage value. The annual cash inflows (before taxes) are estimated at $25,000, with annual cash outflows (before taxes) of $5,000. The annual net cash inflow from the project is computed as follows (assuming straight-line depreciation and a 40% tax rate):

Cash inflows $ 25,000
Cash outflows 5,000
Net cash inflow before taxes $ 20,000
Less:  40% Income Tax Expense (20,000 x 40%) – 8,000
Net cash inflow after taxes (ignoring depreciation) (1) $ 12,000
Depreciation expense ($ 50,000/8 years) $ 6,250
Income tax rate    x 40%
Depreciation tax savings (2) $ 2,500
Annual net cash inflow, years 1-8 (1) + (2) $ 14,500

The annual net cash inflow from the machine is $14,500 each year for eight years. However, the working capital investment must be considered. The investment of $40,000 in working capital at the start of the project is an additional outlay that must be made when the project is started. The $40,000 would be tied up every year until the project is finished, or in this case, until the end of the life of the machine. At that point, the working capital would be released, and the $40,000 could be used for other investments. Therefore, the $40,000 is a cash outlay at the start of the project and a cash inflow at the end of the project.

The net present value of the project is computed as follows (assuming a 14% minimum desired rate of return):

Net cash inflow, years 1-8 ($14,500 x 4.63886) $67,263
Recovery of investment in working capital ($40,000 x 0.35056) 14,022
Present value of net cash inflows $81,285
Initial cash outlay ($50,000 + $40,000) 90,000
Net present value $(8,715)

The discount factor for the cash inflows, 4.63886, comes from Table 2 in the Appendix at the end of the book, because the cash inflows in this example are a series of equal payments—an annuity. The recovery of the investment in working capital is assumed to represent a single lump sum received at the end of the project’s life. As such, it is discounted using a factor (0.35056) that comes from Table 1 in the Appendix.

The investment is not acceptable because it has a negative net present value. If the working capital investment had been ignored, the proposal would have had a rather large positive net present value of $17,263 ($67,263 net cash inflow – $50,000 initial cost). Thus, it should be obvious that investments in working capital must be considered if correct capital-budgeting decisions are to be made.