276 Corporate Finance
sources. The extra money generated from each rupee of sales over and above that invested in working capital
and operating expenses can be re-invested in additional working capital and operating expenses to generate
more revenue in the next cycle. There are three ways to increase growth rate:
- Speeding cash flow by accelerating receivables collection and improving inventory turnover.
- Reducing cost of sales.
- Raising prices without hurting demand.
Theoretically, it is possible for the components of an operating cycle to assume any value, including zero. This
does not happen in practice. For instance, not maintaining any inventory or forgoing credit sales may not be
advisable. So there is a trade-off between liquidity risk and opportunity loss. Liquidity risk refers to the non-
availability of cash when a liability falls due. This may hurt reputation and in the extreme case, further credit
may be stopped. Opportunity loss is the risk of losing potential sale due to non-availability of inventory or
cash to support credit sales. The firm will be losing out on potential business.
Assume that the current sales are Rs 100 crore, and the company expects the sales to increase to Rs 150
crore. Current asset efficiency (assets/sales) is 0.50. Therefore, additional assets required to generate an
additional Rs 50 crore of sales equal 0.5 × 50 = Rs 25 crore. This can be partly funded by profits. Assume
that the current return on sales is 5 percent, the next year profit will be 0.05 × 150 = Rs 7.5 crore. The funding
shortfall is, therefore, Rs (25 – 7.5) = Rs 17.5 crore.
The funding shortfall can be met by improving asset efficiency (because of which the actual assets required
would be less), improving profit margins (because of which actual profits would be higher than expected)
and incurring liabilities (including new equity).
The Impact of Working Capital Investment on Shareholder Value
The value of a company or a project is the present value of free cash flows discounted at WACC.
Free cash flow = NOPAT + Depreciation – Capital expenditure – NWC
= [(Sales in a year) (1+ sales growth rate) (operating margin) (1-tax rate)] – Capex – NWCSince free cash flow is a function of net working capital, reducing investment in working capital for a given
level of sales (growth) increases cash flows and, hence, the stock price. An example will clarify the point.
A company currently has sales of Rs 1.7 crore. Sales are expected to grow at 15 percent for the next 5 years;
profit margin is expected to be 12 percent; tax rate is 35 percent; incremental capital expenditure and working
capital are expected to be 25 percent and 15 percent of the increase in sales respectively. Free cash flows are
expected to grow at 7 percent after the fifth year in perpetuity. WACC is 12 percent.
(in Rs million)
Sales
2000 2001 2002 2003 2004 2005Sales 17 19.55 22.50 25.90 29.80 34.30
Operating profit 2.35 2.70 3.10 3.58 4.12
Taxes 0.82 0.95 1.08 1.25 1.44
Capex 0.64 0.74 0.85 0.975 1.125
NWC 0.384 0.444 0.51 0.585 0.675
Free cash flow 0.506 0.566 0.66 0.77 0.88