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Hi,
I just had a go at question 1 from the June 2013 exam, and I’m confused about the working capital element.
The question states “In addition to the initial cost of the new machinery, initial investment in working capital of $500,000 will be required. Investment in working capital will be subject to the general rate of inflation, which is expected to be 4·7% per year”.
The question ask for the NPV for 4 years. On that basis, I thought that working capital for year 0 should be ($500,000), year 1 ($24,000), year 2 ($24,000), year 3 ($26,000) and year 4 $574,000.
The answer is ($24,000), ($25,000), ($26,000) and ($27,000) for years 0-3 respectively.
What am I doing wrong? Thanks.
In year 1, the extra working capital needed will be 4.7% x 500 = 24.
The total working capital is now 500 + 24 = 524
So in year 2, the extra needed will be 4.7% x 524 = 25.
The total is now 524 + 25 = 549
So in year 3, the extra needed will be 4.7% x 549 = 25.
…..and so on 🙂Thanks for taking the time to explain it to me.
I think my initial confusion was caused by me thinking that they hadn’t deducted the 500 in year 0, but they had, it’s the way they set up their workings which fooled me.
However, I notice that in year 4 they don’t collect back the working capital. Is this because it’s an ongoing project? I added back the 574, which seems to be wrong.
It is because it is an ongoing project (although it is unlikely that you would be penalised if you did bring back the working capital as we usually do).
That’s reassuring to know, because I think that’s the only mistake I made. Thanks again!
John, how do you know it is an ongoing project? it’s not stated in the question. (just curious although candidate will not be penalised on recovering the working capital) – and also, for example in June 13, the working capital(incremental) in year 4 is (27), however if we recover the working capital, the figure will not be (27), instead it will be the new inflated working capital 500 x 1.047^3
It is stated in the question in the first two lines 🙂
We are buying the machine to cope with increased demand, which will presumably continue because in the second line it says that after four years the machine will be replaced.
If the working capital were to be recovered at time 4, then it would be the total of the previous working capital outflows, i.e. 500 + 24 + 25 + 26 = 575 (as neilsolaris wrote above – the difference is simply rounding and is irrelevant)
here comes the problem again in December 2008. Question 3. it says the “machine was purchased to satisfy the increasing demand of the product”, but, the initial working capital together with the inflation was recovered in the final year of it’s operating life.
Is there’s aany other ways to know whether need to recover the working capital or not?
Since, in this question, the decision of the financial accepatability will change without the working capital being recovered.
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