Planning Capital Expenditure 295Treatment of Net Working Capital
Changes in inventory, accounts receivable, and accounts payable are included
in the cash-f low calculation but not in EBT. Changes in the components of
working capital directly impact cash f low, but they are not deductible for tax
purposes. When a firm buys inventory, it has essentially swapped one asset,
(cash) for another asset (inventory). Though this is a negative cash f low, it is not
considered a deductible expenditure for tax purposes.
Similarly, a rise in accounts receivable means that cash that other wise
would have been in the company coffers is now owed to the company instead.
Thus, an increase in accounts receivable effectively sucks cash out of the com-
pany and must be treated as a cash outf low. Increasing accounts payable has
the opposite effect.
One way to gain perspective on the impact of accounts payable and ac-
counts receivable on a company’s cash f low is to think of them as adjustments
to sales and costs of goods sold. If a company makes a sale but the customer has
not yet paid, clearly there is no cash f low generated from the sale. Though the
sales variable will increase, the increase in accounts receivable will exactly off-
set that increase in the cash f low computation. Similarly, if the company incurs
expenses in the manufacture of the goods sold but has not yet paid its suppliers
for the raw materials, the costs of goods sold will be offset by the increase in
accounts payable.
Depreciation
According to a straight-line depreciation schedule, depreciation in each year is
the initial cost of the plant or equipment divided by the number of years over
which the asset will be depreciated. So, the $8 million plant depreciated over
10 years generates depreciation of $800,000 each year. Land is generally not
depreciated. Straight-line depreciation is but one acceptable method for deter-
mining depreciation of plant and equipment. The tax authorities often sanction
other methods and schedules.
Windfall Profit and Windfall Tax
In order to compute windfall profit and windfall tax, we must be able to track
an asset’s book value over its life. Book value is the initial value minus all pre-
vious depreciation. For example, the brewery initially has a book value of $8
million, but that value falls $800,000 per year due to depreciation. At the end
of the first year, book value falls to $7.2 million. By the end of the second year,
following another $800,000 of depreciation, the book value will be $6.4 mil-
lion. By the end of the tenth year, when the brewery is fully depreciated, the
book value will be zero.
Windfall profit is the difference between the salvage value and book
value. We are told the beer company will be able to sell the old brewery for