a very very clear lecture, always not sure about working capital bit but you explained this so well, and it is actually very simple, almost had a eureka moment! Many thanks John!
The fact that we get “back” our working capital makes no sense. I know you don’t make the questions and you are trying to prepare us for the exam….. BUT in practice what happens ? We buy are inventory, we generate cash flows and at the end …..it magically is left over us. In the form of what ?
Either it shouldn’t be called working capital or it shouldn’t be expected to be “left over”. For an exam that is supposed to be preparing us to make practical decisions, this is silly.
I know, know. Rant over. Will do it in this way in the exam.
You are wrong – we do effectively get back the working capital.
Let me give you a simple example. Inventory is part of working capital. Suppose we use $1000 of materials each year – we show a cash outflow of $1000 each year. Suppose we decide we need to carry $100 of inventory to keep things going. We show a working capital outflow of $100 at time 0. We still show an outflow of $1000 a year for materials. However in the final year we won’t actually buy $100 materials because we won’t need any inventory at the end of the project. So in the final year we use the $100 in inventory and therefore only actually pay out cash of $900 for the extra materials needed. In that way we are effectively getting back the working capital.
It is not silly – it is very sensible and is practical 馃檪
I understand what you are saying. I really do. Technically it is a separate cash flow. but with all this years of modelling and forecasting being left with the exact same working capital we start with is a little …unrealistic. I understand in Ex 2 our cash flow model is very simplistic..
I really don’t want to belabor the issue . It is a theoretical point. I get it.
Thank you for your reply, and more importantly thank you for the lectures !!!
Hi john, I am confused about the concept of working capital recovery, as you said we assume to recover working capital at the end of project, but in cases where incremental working capital is required, why we assume it to be recovered in the next year? for example if we required another 30000 of working capital in second year, we’ll only be required to invest an additional 10000, because the 20000 invested previously would have been recovered, right? Similarly when the working capital requirement reduces from previous year we show it as an inflow because we assume it to be recovered, lets say if 10000 working capital is required for second year and as we have invested 20000 previously we would show an inflow of 10000 in year 1 (i.e the start of year 2), assuming the 10000 to be recovered before the end of project (by the end of year 1)?
My second question is that as you said that op cash flows are profits expressed in terms of cash, so its basically the net, of inflow from sales, and the cash paid out for inventory, labour, overheads etc, so why we need to account for working capital separately? I mean, working capital is the cash stuck in receivables & inventory, & if we are taking cash flows for each year, isn’t it that these things have already been accounted for?
What you have written in your first comment is correct.
With regard to your second comment, in the calculation of profit will be the cost of the goods that were sold. If, for example, you increased inventories (which is part of working capital) then you would be paying out extra cash.
Not necessarily recovered. It is adjusted on a yearly basis (if the question tells you to) which might mean more is needed or less is needed, and then is all recovered at the end of the project (again, unless the question says not) 馃檪
Now I got it, the amount given in questions for working capital is the total amount that would be required for working capital, if more than previous, more needs to be invested. If its less, it means that the amount previously invested, is released, thus showing an inflow. Thanks John 馃檪
So if extra working capital is needed in later years, then it is relevant – the extra is a cash outflow. (And at the end of the project we assume all the working capital is recovered, unless told differently)
Sir Can you please explain thn Why in DEC 2015 Investment appraisal question the working capital were not recovered? The question no where says that working capitals are irrecoverable. I am sorry if this is not the place to ask this question but this is confusing me. Thank you
It is because the question says that the machine will be replaced in 4 years time. Therefore presumably the working capital will still be needed because the product will still be produced. (The examiner did this once before in another question, but did say that full marks would still be given if the working capital was recovered. I would guess he did the same this time.)
The correct place to ask is the F9 Ask the Tutor Forum 馃檪
Thank You So much for your reply that clears out the confusion. I understand this is not the right place:P but the problem was so much related it will surely clear for others as well 馃檪
Whats the logic behind getting the working capital at the end of the life of the project? Why not treat it as any other cost and include it only once as a relevant cost.
The working capital is the money needed to finance higher inventories etc. that will be needed during the life of the project.
Once the project has finished, we assume that we no longer need to carry extra inventories etc. and therefore the money is released and is therefore an inflow.
The video is working fine and so the problem must be at your end. Go to the support page – the link is above – and you should be able to find help there.
Thankyou for the reply, I think maybe it’s a apple device problem. At a certain point it stops but if you skip it and go to a later part starts working. Happened with a couple of other lectures too. Will try laptop next time. Thanks again. The lectures are very helpful, and it all starts to make sense. Thankyou!!!
Goodday sir. Please how did you get the 20,000. used for working capital. Am a little confused because usually we are supposed to be given a figure for working capital and its usually spread within all years by minusing it from the initial amount and then recouped at the end of the life of the project. pls help!!!! Thank you
The second sentence of the questions says ‘In addition a further $20,000 working capital will be required at the start of the project’ (I assume that you have downloaded the course notes that go with these lectures?).
We do not usually ‘spread within all years’ – the question will make it clear if there are any more outflows necessary.
We do assume that the working capital is released at the end of the project, and I have done that in this example.
I noticed that in the answer provided on the ACCA website to Question 1 for the June 2013 F9 Paper, the working capital was not stated in year 1 and taken out in the last year but what was stated in each year was the increment (amount) caused by the yearly inflation rate of 4.7%. Why was this done that way? No where in the answer was the 500,00 working capital included.
The initial working capital of 500,000 is treated as an outflow at time 0 in the answer, which is what we normally do. The question says that it is to increase by 4.7% each year and so the extra amount has been charged in each subsequent year – this is quite common in the exam.
The one thing that the examiner has not done in his answer is bring in the recovery of the working capital at the end of the machines life. If you had brought it in (as I would have done) then you would still have got full marks. (The reason that he did not bring it in is because the question says that the machine is to be replaced, and he has therefore assumed that the working capital will still be needed.)
ennydurman says
a very very clear lecture, always not sure about working capital bit but you explained this so well, and it is actually very simple, almost had a eureka moment! Many thanks John!
John Moffat says
Thank you for your comment 馃檪
henrieze says
Hi John,
great lecture. please clarify why we get the working capital ($20000) back at the end, I thought it was already expensed?
John Moffat says
Please read my reply to the post below 馃檪
bballhawk says
The fact that we get “back” our working capital makes no sense. I know you don’t make the questions and you are trying to prepare us for the exam….. BUT in practice what happens ? We buy are inventory, we generate cash flows and at the end …..it magically is left over us. In the form of what ?
Either it shouldn’t be called working capital or it shouldn’t be expected to be “left over”. For an exam that is supposed to be preparing us to make practical decisions, this is silly.
I know, know. Rant over. Will do it in this way in the exam.
John Moffat says
You are wrong – we do effectively get back the working capital.
Let me give you a simple example. Inventory is part of working capital. Suppose we use $1000 of materials each year – we show a cash outflow of $1000 each year. Suppose we decide we need to carry $100 of inventory to keep things going. We show a working capital outflow of $100 at time 0. We still show an outflow of $1000 a year for materials. However in the final year we won’t actually buy $100 materials because we won’t need any inventory at the end of the project. So in the final year we use the $100 in inventory and therefore only actually pay out cash of $900 for the extra materials needed. In that way we are effectively getting back the working capital.
It is not silly – it is very sensible and is practical 馃檪
bballhawk says
I understand what you are saying. I really do.
Technically it is a separate cash flow. but with all this years of modelling and forecasting being left with the exact same working capital we start with is a little …unrealistic. I understand in Ex 2 our cash flow model is very simplistic..
I really don’t want to belabor the issue . It is a theoretical point. I get it.
Thank you for your reply, and more importantly thank you for the lectures !!!
rafsanjjjj says
Sir,
Why we deduct sunk cost here?
rafsanjjjj says
Here $100,000 is sunk cost, isn’t it?
John Moffat says
It certainly isn’t a sunk cost!! We are deciding whether the project is worth doing – if we do not do it then we won’t spend the $100,000!
(A sunk cost is one that we have already spent or committed to spend)
Mahrukh says
Hi john,
I am confused about the concept of working capital recovery, as you said we assume to recover working capital at the end of project, but in cases where incremental working capital is required, why we assume it to be recovered in the next year? for example if we required another 30000 of working capital in second year, we’ll only be required to invest an additional 10000, because the 20000 invested previously would have been recovered, right?
Similarly when the working capital requirement reduces from previous year we show it as an inflow because we assume it to be recovered, lets say if 10000 working capital is required for second year and as we have invested 20000 previously we would show an inflow of 10000 in year 1 (i.e the start of year 2), assuming the 10000 to be recovered before the end of project (by the end of year 1)?
Mahrukh says
My second question is that as you said that op cash flows are profits expressed in terms of cash, so its basically the net, of inflow from sales, and the cash paid out for inventory, labour, overheads etc, so why we need to account for working capital separately?
I mean, working capital is the cash stuck in receivables & inventory, & if we are taking cash flows for each year, isn’t it that these things have already been accounted for?
John Moffat says
What you have written in your first comment is correct.
With regard to your second comment, in the calculation of profit will be the cost of the goods that were sold. If, for example, you increased inventories (which is part of working capital) then you would be paying out extra cash.
Mahrukh says
So effectively, working capital is being recovered on an yearly basis?
John Moffat says
Not necessarily recovered. It is adjusted on a yearly basis (if the question tells you to) which might mean more is needed or less is needed, and then is all recovered at the end of the project (again, unless the question says not) 馃檪
Mahrukh says
Now I got it, the amount given in questions for working capital is the total amount that would be required for working capital, if more than previous, more needs to be invested. If its less, it means that the amount previously invested, is released, thus showing an inflow.
Thanks John 馃檪
John Moffat says
You are welcome 馃檪
nsonga says
Why do we charge the working capital in year 0rather than in year 1?
John Moffat says
There is no such thing as year 0 or year 1.
Time 0 is a point in time and is the start of the first year.
Time 1 is one year later – it is the end of the first year and the start of the second year.
Time 2 is another year later – the end of the second year and the start of the third year.
Unless you are told differently in a question, working capital is first needed at the start of the first year which is time 0.
Victoria says
Hi John,
Can you explain what Incremental Working Capital is, and is relevant for the NPV calculation?
Thank you in advance.
John Moffat says
Incremental means extra.
So if extra working capital is needed in later years, then it is relevant – the extra is a cash outflow. (And at the end of the project we assume all the working capital is recovered, unless told differently)
inverter says
Sir Can you please explain thn Why in DEC 2015 Investment appraisal question the working capital were not recovered? The question no where says that working capitals are irrecoverable. I am sorry if this is not the place to ask this question but this is confusing me. Thank you
John Moffat says
It is because the question says that the machine will be replaced in 4 years time. Therefore presumably the working capital will still be needed because the product will still be produced.
(The examiner did this once before in another question, but did say that full marks would still be given if the working capital was recovered. I would guess he did the same this time.)
The correct place to ask is the F9 Ask the Tutor Forum 馃檪
inverter says
Thank You So much for your reply that clears out the confusion. I understand this is not the right place:P but the problem was so much related it will surely clear for others as well 馃檪
John Moffat says
You are welcome 馃檪
(but others do look at the Ask the Tutor Forum 馃檪 )
Arun says
Hi John,
Whats the logic behind getting the working capital at the end of the life of the project? Why not treat it as any other cost and include it only once as a relevant cost.
Thanks.
John Moffat says
The working capital is the money needed to finance higher inventories etc. that will be needed during the life of the project.
Once the project has finished, we assume that we no longer need to carry extra inventories etc. and therefore the money is released and is therefore an inflow.
Na54 says
The video works for one minute and then it says cannot load movie. Tried opening in different browsers still no luck. Please help.
John Moffat says
The video is working fine and so the problem must be at your end.
Go to the support page – the link is above – and you should be able to find help there.
Na54 says
Thankyou for the reply, I think maybe it’s a apple device problem. At a certain point it stops but if you skip it and go to a later part starts working. Happened with a couple of other lectures too. Will try laptop next time. Thanks again.
The lectures are very helpful, and it all starts to make sense. Thankyou!!!
Oboro says
Goodday sir. Please how did you get the 20,000. used for working capital. Am a little confused because usually we are supposed to be given a figure for working capital and its usually spread within all years by minusing it from the initial amount and then recouped at the end of the life of the project. pls help!!!! Thank you
John Moffat says
The second sentence of the questions says ‘In addition a further $20,000 working capital will be required at the start of the project’ (I assume that you have downloaded the course notes that go with these lectures?).
We do not usually ‘spread within all years’ – the question will make it clear if there are any more outflows necessary.
We do assume that the working capital is released at the end of the project, and I have done that in this example.
musemma says
Hi John,
I noticed that in the answer provided on the ACCA website to Question 1 for the June 2013 F9 Paper, the working capital was not stated in year 1 and taken out in the last year but what was stated in each year was the increment (amount) caused by the yearly inflation rate of 4.7%. Why was this done that way? No where in the answer was the 500,00 working capital included.
John Moffat says
The initial working capital of 500,000 is treated as an outflow at time 0 in the answer, which is what we normally do.
The question says that it is to increase by 4.7% each year and so the extra amount has been charged in each subsequent year – this is quite common in the exam.
The one thing that the examiner has not done in his answer is bring in the recovery of the working capital at the end of the machines life. If you had brought it in (as I would have done) then you would still have got full marks.
(The reason that he did not bring it in is because the question says that the machine is to be replaced, and he has therefore assumed that the working capital will still be needed.)
rnhemi says
hi, the lectures are good and helpful. is there a way to download the lectures and use them as I travel.
aaymedh says
right now for NPV ,we only look at working capitals effect on cash flows without considering profit or loss
geenii says
because working capital invested at the start of project that’s why it can’t be spread across the whole project
mbangweta says
this keeps getting better and better to understand
kboodoo says
Why is the Working Capital not spread across the life of the project ?
eboakye says
in practice it it but in theory it is not.
vazquezwinter says
Why we need to assume the working capital can be pay back in the end of project?if the project make a loss.
siddiqui01 says
cuz john said it lol