CHAPTER 8 Capital Budgeting Cash Flows 369
- When changes in net working capital apply to the initial investment associated with a proposed capital expendi-
ture, they are for convenience assumed to be instantaneous and thereby occurring at time zero. In practice, the change
in net working capital will frequently occur over a period of months as the capital expenditure is implemented. - Throughout the discussions of capital budgeting, all assets evaluated as candidates for replacement are assumed
to be depreciable assets that are directly used in the business, so any losses on the sale of these assets can be applied
against ordinary operating income. The decisions are also structured to ensure that the usable life remaining on the
old asset is just equal to the life of the new asset; this assumption enables us to avoid the problem of unequal lives,
which is discussed in Chapter 10.
TABLE 8.4 Calculation of Change
in Net Working Capital
for Danson Company
Current account Change in balance
Cash $ 4,000
Accounts receivable 10,000
Inventories (^8) , (^0) (^0) (^0)
(1) Current assets $22,000
Accounts payable $ 7,000
Accruals (^2) , (^0) (^0) (^0)
(2) Current liabilities (^9) , (^0) (^0) (^0)
Change in net working capital [(1)(2)]
$
1
3
,
0
0
0
change in net working capital
The difference between a change
in current assets and a change in
current liabilities.
for more cash to support expanded operations, more accounts receivable and
inventories to support increased sales, and more accounts payable and accruals to
support increased outlays made to meet expanded product demand. As noted in
Chapter 3, increases in cash, accounts receivable, and inventories are outflows of
cash,whereas increases in accounts payable and accruals are inflows of cash.
The difference between the change in current assets and the change in current
liabilities is the change in net working capital.Generally, current assets increase
by more than current liabilities, resulting in an increased investment in net work-
ing capital. This increased investment is treated as an initial outflow.^8 If the
change in net working capital were negative, it would be shown as an initial
inflow. The change in net working capital—regardless of whether it is an increase
or a decrease—is not taxablebecause it merely involves a net buildup or net
reduction of current accounts.
EXAMPLE Danson Company, a metal products manufacturer, is contemplating expanding its
operations. Financial analysts expect that the changes in current accounts summa-
rized in Table 8.4 will occur and will be maintained over the life of the expansion.
Current assets are expected to increase by $22,000, and current liabilities are
expected to increase by $9,000, resulting in a $13,000 increase in net working cap-
ital. In this case, the increase will represent an increased net working capital invest-
ment and will be treated as a cash outflow in calculating the initial investment.
Calculating the Initial Investment
A variety of tax and other considerations enter into the initial investment calcula-
tion. The following example illustrates calculation of the initial investment
according to the format in Table 8.2.^9