Introduction to Corporate Finance

PArT 3: CAPITAL BUDGETING

example

Electrocom Manufacturing purchased $100,000 worth

of new computers three years ago. Now it is replacing

these machines with newer, faster computers. The

company has a 30% tax rate. The Tax Commissioner

has suggested that computers have a useful life of four

years. Using the diminishing value method, the annual

percentage depreciation will be 50% (calculated using

200% × [1/Effective Asset Life]). The company has

depreciated 50.0% of the remaining asset values each

year, leaving a book value of $12,500. Electrocom sells

its old computers to another company for $10,000.

This allows Electrocom to report a loss on the sale

of $2,500 ($12,500 book value – $10,000 sale price).

Assuming that Electrocom’s business is otherwise

profitable, it can deduct this loss from other pre-tax

income, resulting in a tax savings of $750 (0.30 ×

$2,500). In the analysis of the new investment project,

this $750 is treated as a cash inflow.

10 -1d NET WOrKING CAPITAL

Consider a retail company evaluating the opportunity to open a new store. Part of the cash outflow of this

investment involves expenditures on fixed assets such as shelving, cash registers and merchandise displays;

but stocking the store with inventory constitutes another important cash outflow. A portion of this cash

outflow may be deferred if the company can purchase inventory from suppliers on credit. By the same

token, cash inflows from selling the product may be delayed if the company sells to customers on credit.

Just as a company must account for cash flows on fixed assets, it must also weigh the cash inflows

and outflows associated with changes in net working capital. The definition of net working capital is simply

the difference between current assets and current liabilities. An increase in net working capital represents

a cash outflow. Net working capital increases if current assets rise (for example, if the company buys more

inventory) or if current liabilities fall (for example, if the company pays down accounts payable). As noted in

Chapter 2 (see Table 2.5 on page 41), any increase (decrease) in a current asset account or any decrease

(increase) in a current liability account results in a cash outflow (inflow).^3 Net working capital decreases

when current assets fall (as when a company sells inventory) or when current liabilities increase (as when

the company borrows from suppliers). Therefore, a decrease in net working capital represents a cash inflow.

example

Have you ever noticed the cottage industries that

temporarily spring up around certain big events?

Think about the booths that open in shopping

malls near the end of each year and sell nothing

but calendars. Suppose you are evaluating the

opportunity to operate one of these booths from

November until January. You begin by ordering (on

credit) $15,000 worth of calendars. Your suppliers

require a $5,000 payment on the first day of each

month, starting in December. You anticipate that

you will sell (entirely on a cash basis) 30% of your

inventory in November, 60% in December and

10% in January. You plan to keep $500 in the cash

register until you close the booth on 1 February.

Your balance sheet at the beginning of each month

looks like this:

LO10.2

net working capital
The difference between a
company’s current assets and
its current liabilities

3 Of course, one important current asset account is cash. It may seem counterintuitive to argue that if the balances in the cash account increase, then

that should be treated as a cash outflow. However, consider again the example of a new retail store. If the company opens a new store, a small amount

of cash will have to be held in that store for transactions purposes. Holding fixed the amount of cash that the company maintains in all of its other

stores and in its corporate accounts, opening a new store requires a net increase in the company’s cash holdings. If the company did not open the new

store, then it could invest the cash that it would have held in reserve in the new store in a different project. Likewise, consider what happens if the

company decides to close one of its stores. The cash kept in reserve at that location can be redeployed for another use, so reducing cash at that store

represents a cash inflow to the company as a whole. As we will see in Chapter 19, cash management tools have become so sophisticated today that

few investments require significant changes in cash holdings. Changes in the other working capital items, such as inventory, receivables and payables,

typically have a much greater cash flow impact than changes in cash balances.