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Gunning Industries is considering investment in a new machine which has a five year life. The investment in the new machine would also require an immediate increase in working capital of $35,000, which would be fully recovered at the end of five years. Gunning is subject to a 40% corporate tax rate and has a cost of capital of 10%.
What is the effect of working capital on the net present value of the investment?
A.($7,959)
B.($10,680)
C.($13,265)
D.($35,000)The correct answer is C.
Time Cash Discount PV
flow factor $
t0 (35,000) 1 (35,000) Initial investment
t5 35,000 0.621 21,735 RecoveryOverall effect (13,265)
Tutorial note: Working capital flows have no tax effect.
QUERY: I don’t understand why they are working out the present values for these cash flows.
In CR questions, they were just copying the working capital calculations from the Working notes as they are without computing the present values.The effect of working capital on the net present value (NPV) of the investment is calculated by considering the initial outflow and the recovery of working capital at the end of the project’s life, discounted at the cost of capital.
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