Net Working Capital

Normally, a project will require that the firm invest in net working capital in addition to long-term assets. For example, a project will generally need some amount of cash on hand to pay any expenses that arise. In addition, a project will need an initial investment in inventories and accounts receivable (to cover credit sales). Some of the financing for this will be in the form of amounts owed to suppliers (accounts payable), but the firm will have to supply the balance. This balance represents the investment in net working capital.

It's easy to overlook an important feature of net working capital in capital budgeting. As a project winds down, inventories are sold, receivables are collected, bills are paid, and cash balances can be drawn down. These activities free up the net working capital originally invested. So, the firm's investment in project net working capital closely resembles a loan. The firm supplies working capital at the beginning and recovers it towards the end.

erosion

The cash flows of a new project that come at the expense of a firm's existing projects.

2If the asset in question is unique, then the opportunity cost might be higher because there might be other valuable projects we could undertake that would use it. However, if the asset in question is of a type that is routinely bought and sold (a used car, perhaps), then the opportunity cost is always the going price in the market because that is the cost of buying another similar asset.

3More colorfully, erosion is sometimes called piracy or cannibalism.

Ross et al.: Fundamentals I IV. Capital Budgeting I 10. Making Capital I I © The McGraw-Hill of Corporate Finance, Sixth Investment Decisions Companies, 2002

Edition, Alternate Edition

CHAPTER 10 Making Capital Investment Decisions 315

0 0

Post a comment