bre44380_ch06_132-161.indd 141 09/30/15 12:46 PM
Chapter 6 Making Investment Decisions with the Net Present Value Rule 141
IM&C estimates the nominal opportunity cost of capital for projects of this type as 20%.
When all cash flows are added up and discounted, the guano project is seen to offer a net pres-
ent value of about $3.5 million:
NPV = −12,600 −1,630
_____
1.20+2,381
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(1.20)^2+6,205
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(1.20)^3+10,685
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(1.20)^4+10,136
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(1.20)^56,110
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(1.20)^6+3,444
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(1.20)^7= +3,520, or $3,520,000Separating Investment and Financing Decisions
Notice that following our earlier Rule 4, we took no notice of how the guano project is
financed. We did not deduct any debt proceeds from the initial investment, and we did not
deduct interest and principal payments from the cash inflows. Common practice is to forecast
cash flows as if the project is all-equity financed and to estimate separately any additional
value resulting from the financing decision.
Investments in Working Capital
Now here is an important point. You can see from line 2 of Table 6.2 that working capital
increases in the early and middle years of the project. Working capital summarizes the net
investment in short-term assets associated with a firm, business, or project. Its most important
components are inventory, accounts receivable, and accounts payable. The guano project’s
requirements for working capital in year 2 might be as follows:
Working capital = inventory + accounts receivable – accounts payable$1,289 = 635 + 1,030 – 376
Why does working capital increase? There are several possibilities:
- Sales recorded on the income statement overstate actual cash receipts from guano
shipments because sales are increasing and customers are slow to pay their bills.
Therefore, accounts receivable increase. - It takes several months for processed guano to age properly. Thus, as projected sales
increase, larger inventories have to be held in the aging sheds. - An offsetting effect occurs if payments for materials and services used in guano
production are delayed. In this case accounts payable will increase.
The additional investment in working capital from year 2 to 3 might be
Additional
investment in
working capital= increase in
inventory+increase in
accounts
receivable−increase in
accounts
payable$1,972 = 972 + 1,500 − 500A more detailed cash-flow forecast for year 3 would look like Table 6.3.
There is an alternative to worrying about changes in working capital. You can estimate
cash flow directly by counting the dollars coming in from customers and deducting the dollars
going out to suppliers. You would also deduct all cash spent on production, including cash
spent for goods held in inventory. In other words,