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Dear sir,
If you look at F9 Dec 2013 paper question 1.
They mentioned that level of working capital investment is 10% of sales revenue. I understand that the increment should be used for cashflow.
However, the answer was different from what I thought of just putting the increment per year.
Can you please tell me the proper method to tackling working capital investment?
Thank you!
It is the increment. At the start of each year, the extra working capital is needed for the following year.
(So at time 1 is needed the extra working capital for the second year, and so on)If you are still not clear then ask about a specific figure and I will try and explain.
Darn Co has undertaken market research at a cost of $200,000 in order to forecast the future cash flows of an investment project with an expected life of four years, as follows:
Year 1 2 3 4
Sales revenue ($000) 1,250 2,570 6,890 4,530
Costs ($000) 500 1,000 2,500 1,750These forecast cash flows are before taking account of general inflation of 4·7% per year. The capital cost of the investment project, payable at the start of the first year, will be $2,000,000. The investment project will have zero scrap value at the end of the fourth year.
(The level of working capital investment at the start of each year is expected
to be 10% of the sales revenue in that year.)This was the question that i did.
I do not understand why for Year 1, the working capital would be the incremental value of 150.86 instead of 130.88. I am very confuse on how to do working capital for DCF.
Answer as below.
Year 1 2 3 4
Inflated sales revenue ($000) 1,308·75 2,817·26 7,907·87 5,443·58
Working capital ($000) 130·88 281·73 790·79 544·36
Incremental ($000) (130·88) (150·86) (509·06) 246·43Thanks
The actual sales revenue in the first year is 1250 x 1.047 = 1308.75
Therefore the working capital needed at the start of the first year is 130.88.
The first year starts now (time 0) and so there is an outflow at time 1 of 130.88.The actual sale revenue in the second year is 2570 x (1.047^2) = 2817.26.
So the working capital needed at the start of the second year is 281.73.
The second year starts in one years time (time 1) and so there is an outflow at time 1 of 281.73 – 130.88 = 150.86.The free lectures on relevant cash flows for investment appraisal should help you.
Sir, one more question on the same question. I am not able to understand how did we get inflated sales revenue for year 2 as 2,817.26 as against the normal sales revenue of 2,570?
I understood that in the first year the below has been done as1250*1.047=1,308.75
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