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AW Co needs to have $100,000 working capital in place immediately for the start of a 2-year project. The
amount will stay constant in real terms. Inflation is running at 10% per annum, and AW Co’s money cost of
capital is 12%.
What is the present value of the cash flows relating to working capital?Sir, can we convert the money cost of capital to real cost of capital through the fisher formula and then discount the real cash flows? In the answer, the cash flow is inflated and then discounted with money cost of capital.
Also, why is working capital flow included in time 1, wouldn’t we only need it at time 0 or it because it says that the amount will stay constant?
They need $100,000 at time 0.
If it is to be kept constant in real terms, then it means they need it to be $110,000 at time 1, and since they already have $100,000, it means they need an extra outflow at time 1 of $10,000 so for it to now be $110,000.
At time 1 they need it to have grown to $121,000 (110,000 x 1.1), and since they already have $110,000 they need an extra outflow of $11,000 at time 2.
I have asked you before, but you have not answered me – have you actually watched all of my free lectures?
Yes I’ve seen all the lectures sir. The wording of the question was just confusing to me, that’s why I asked.
Sir you didn’t answer my second question about discounting the real cash flows with the real cost of capital instead of inflating the flows and then discounting with the money cost of capital
Discounting the real cash flows at the real cost of capital only works if all of the cash flows are inflating at the same rate as the general rate of inflation (it is the general rate of inflation that is used in the Fisher formula).
In practice, and in almost all exam questions, it is not the case that all of the flows inflate at the same general rate of inflation. Therefore we have to calculate the nominal flows (by inflating at the relevant rates) and then discount then at the nominal/actual cost of capital.
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