10: Cash Flow and Capital Budgeting1 Oct. 1 Nov. 1 Dec. 1 Jan. 1 Feb.
Cash $0 $500 $500 $500 $0
Inventory 0 15,000 10,500 1,500 0
Accounts payable 0 15,000 10,000 5,000 0
Net working capital 0 500 1,000 –3,000 0
Monthly net working capital change NA + 500 + 500 –4,000 +3,000The cash flows associated with changes in net working capital are as follows:- $500 cash outflow from October–November
- $500 cash outflow from November–December
- $4,000 cash inflow from December–January
- $3,000 cash outflow from January–February.
Since the table shows the financial position at the
start of each month, any cash flows that occur during
a month are reflected in the position shown for the
following month.
Notice that at the start of November, purchases
of inventory are entirely on credit, so the increase in
inventory is exactly offset by an increase in accounts
payable. The only working capital cash outflow
occurs because you must raise $500 to put in the
cash register. During November, sales reduce your
inventory by $4,500 (inflow), but you pay suppliers
$5,000 (outflow). You still have the same amount
in the cash register as before, $500, so on netyou have an outflow of $500, exactly equal to the
increase in net working capital from the prior month.
During the month of December, sales reduce your
inventory by $9,000 (inflow), and you pay $5,000 to
suppliers (outflow). That leaves you with cash inflow
of $4,000, equal to the decrease in net working
capital during the month. By 1 February, sales reduce
your inventory by the remaining $1,500 in calendars
(inflow), you empty $500 from the cash register
(inflow), and you pay the last $5,000 to suppliers
(outflow). The net effect is a $3,000 cash outflow
during January.^4example4 In this section we are looking only at the working capital cash flows associated with this project. We have not considered any fixed asset
investment up-front, nor have we included the profits from selling calendars at a markup, or the labour costs of operating the booth. These
issues would certainly be considered in a complete analysis of the investment.10 -1e TErMINAL VALUE
Some investments have a well-defined life span. The life span may be determined by the physical life of
a piece of equipment, by the length of time until a patent expires or by the period of time covered by a
leasing or licensing agreement. Often, however, investments have an indefinite life. For example, when
a company acquires another company as a going concern, as noted in the share valuation discussion in
Chapter 5, it generally expects the acquired company’s assets to continue to generate cash flow for a very
long period of time.
When managers invest in an asset with a long life span, they typically do not construct cash flow
forecasts more than five to 10 years into the future. These long-term forecasts can be inaccurate to
the point that the fine detail in an item-by-item cash flow projection is not very meaningful. Instead,
managers project detailed cash flow estimates for five to 10 years, then calculate a project’s terminal value,
the value of all of a project’s cash flows beyond a certain date in the future. There are a number of ways
to calculate terminal value.
Perhaps the most common approach to calculating the terminal value is to take the final year of
cash flow projections and make an assumption that all future cash flows will grow at a constant rate.LO10.2
terminal value
The value of all of a project’s
cash flows beyond a certain
date in the future