Three Important Financial Questions
Why an increasing working capital is considered a relevant cost for capital expenditure decisions?
Net-working capital, as we know, is the amount by which a firm’s current assets exceed its current liabilities. When a firm acquires new machinery to expand its level of operations, it experiences an increase in levels of cash, accounts receivable, inventories, accounts payable, and accruals. These increases result from the need for more cash to support expanded operations, more accounts receivable and inventories to support increased sales, and more accounts payable and accruals to support increased outlays made to meet expanded product demand, and that’s the reason why increased working capital is considered as a relevant cost for capital expenditure or for capital budgeting decision. Some important aspects regarding this topics are given below-
- It is a derivation of working capital that is commonly used in valuation techniques such as DCFs (Discounted cash flows).
- If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit.
- When changes in net working capital applied to initial investment associated with a proposed capital expenditure there are conveniently assumed to be instantaneous and they are by occurring at time zero. If the changes in networking capital were negative it’s would be shown as an initial inflow.
- Change in net working capital regardless of whether it is an increase or decrease -is not taxable because it merely involves a net buildup or net reduction or current account.
Why cash flows are considered, not profit, in capital budgeting decisions?
While making capital budgeting decisions, not profit but cash flows are considered. That’s because profit is merely an accounting figure that can be manipulated by doing “window dressing”. It does not show the actual amount of cash available to the firm for supporting the decision. While, on the other hand, cash flows represent the actual amount of cash available to the firm, calculated by adjusting all non-cash expenses (e.g. depreciation) with the net profit of the firm. For that, cash flows are considered in capital budgeting decisions, not profit.
For evaluating capital expenditure alternatives, the firm must determine the relevant cash flows (incremental cash outflow and resulting in subsequent inflows). By applying the cash flows we will get those benefits which are presenting below:
- Decision techniques that capture time value of money;
- Risk factors;
- Financial managers can estimate the impact the investment will have on the firm share price;
- Only those investments that can be expected to increase the stock price should be undertaken.
Occasionally cash outflow intentionally ignored to enhance the attractiveness often propose investment and thereby improving its likelihood of acceptance.
To make a capital budgeting decision we can’t consider profit for the following reason:
- profit manipulation throw through the creative use of elective accounting practices
- It ignores the timing of returns, cash flows available to stockholders, and risk
Three Important Financial Questions – Must Read Questions!
“In the calculation of NPV, depreciation is not deducted from the net cash flow, despite the fact that depreciation is a real economic cost” – critically evaluate this statement.
Yes, in the calculation of NPV, depreciation is not deducted from the net cash flows. NPV is calculated by subtracting a project’s initial investments from the present value of its cash inflows discounted at a rate equal to the firm’s cost of capital. Depreciation, though, represents the use of a previously purchased asset, but is a non-cash expense i.e., the firm does not spend cash for it nor creates any special fund for the same. It is, actually, used for accounting purposes that lead toward a deduction in tax. Thus, it has no effect on cash flows. This is why it is not deducted from the net cash flow in the calculation if NPV.
When we calculate the net present value, the initial investment is subtracted from the present value of cash inflows. In this sophisticated capital budgeting technique, we do not consider depreciation (not deducted from cash flow). Depreciation is a non-cash charge- an expense that is deducted on the income statement but doesn’t involve the actual outlay of cash during the period. Because it shields the firms from taxes by lowering taxable income, the non-cash charge is considered cash inflows.
Depreciation is treated as a separate cash inflow, only gross rather than a net change in fixed assets appears on the statement of cash flows. A firm can have a net loss and still have positive cash flows from operations when depreciation during the period is greater than the net loss. In the statement of cash flows net profit after tax and deprecation are there for treated as separate entities. Economic depreciation is the actual cost of replacing equipment worn out in the Production Process. For all of these reasons, depreciation is a real economic cost.
Three Important Financial Questions – Must Read!