When Projects Require
Working-Capital Investments
Lecture No. 40
Chapter 10
Contemporary Engineering Economics
Copyright © 2006
Contemporary Engineering Economics, 4th
edition, © 2007
What is Working Capital?


Working capital means
the amount carried in
cash, accounts
receivable, and inventory
that is available to meet
day-to-day operating
needs.
How to treat working
capital investments: just
like a capital expenditure
except that no
depreciation is allowed.
Contemporary Engineering Economics, 4th
edition, © 2007
Working Capital Equations



Accounting definition:
 WC = Current Asset – Current Liabilities
 WC = CA - CL
 where WC = changes in working capital
 CA = changes in current assets
 CL = changes in current liabilities
If WC > 0, working capital requirement. With the net change being
positive, the firm has a net requirement of working capital that has to
be financed during the year. Therefore, the WC requirement appears
as uses of cash in the cash flow statement.
If WC < 0, working capital release. If this amount were negative,
there would have been a cash inflow from working capital release,
which could add to the sources of cash.
Contemporary Engineering Economics, 4th
edition, © 2007
Example 10.2 Working Capital
Requirements
Price (revenue) per unit
Unit variable manufacturing costs:
Labor
Material
Overhead
Monthly volume
$10
$2
$1.20
$0.80
833 units
Finished goods inventory to maintain
2 – month supply
Raw materials inventory to maintain
1 – month supply
Accounts payable
30 days
Accounts receivable
60 days
Contemporary Engineering Economics, 4th
edition, © 2007
Required Working Capital Investments
Contemporary Engineering Economics, 4th
edition, © 2007
Cash Flow Statement with Working-Capital
Requirement (Example 10.3)
New entry
related to
working
capital
investment
Contemporary Engineering Economics, 4th
edition, © 2007
Cash Flow Diagram including Working
Capital
$23,331
$43,145
0
1
$48,245 $44,745
2
3
$125,000 Investment in
physical assets
$23,331 Investment in
working capital
Working capital
recovery
$81,619
$42,245
4
5
$23,331
$23,331
0
$23,331
1
$23,331
2
3
4
Years
Working capital recovery cycles
Contemporary Engineering Economics, 4th
edition, © 2007
5
Changes in Profitability

NPW without the Working Capital
Requirement


PW(15%) = $43,152
NPW with the Working Capital Requirement
in the amount of $23,331

PW(15%) = $31,420
The $11,732 reduction in present worth is from the investment tied up
in working capital that results in lost earnings.
Contemporary Engineering Economics, 4th
edition, © 2007
When Projects Results in Negative Taxable
Income

Negative taxable
income (project
loss) means you
can reduce your
taxable income
from regular
business operation
by the amount of
loss, which results
in a tax savings.

Taxable
income
Income
taxes
(35%)
Handling Project Loss
Regular
Business
Project
Combined
Operation
$100M
(10M)
$90M
$35M
?
$31.5M
Tax savings
Tax Savings = $35M - $31.5M
= $3.5M
Or (10M)(0.35) = -$3.5M
Contemporary Engineering Economics, 4th
edition, © 2007
Example 10.5 Project Cash Flows for a
Cost-Only Project


Project Nature: Installing a cooling-fan at Alcoa
Aluminum’s McCook plant to reduce the work-inprocess inventory buildup
Financial Facts:









Required investment: $536,000
Service life: 16 years
Salvage value: 0
Reduction of WIP (working-capital release): $2,121,000
Depreciation Method: 7-year MACRS
Annual electricity cost: $86,000
Income tax rate:40%
MARR: 20%
Develop the project cash flow
Contemporary Engineering Economics, 4th
edition, © 2007
Cash Flow Statement (Table 10.5)
Contemporary Engineering Economics, 4th
edition, © 2007
Measures of Investment Worth for the
Cooling-Fan Project



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

MARR = 20%
PW(20%) =
$991,008
i* = 4.24% and
291.56%
A nonsimple and
mixed investment
RIC = 241.87%
>20%
Good investment!
Contemporary Engineering Economics, 4th
edition, © 2007