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Unformatted text preview: orary working capital is
treated in Chapter 15.
In Figure 12.1, we graph a typical firm’s balance sheet over time. The lines slope
upward, representing a growing firm, but the picture would be equally valid if
the company were unchanging or declining in size. On both sides of the equal
sign, the bottom area represents the long-term: long-term assets on the left and
long-term liabilities and equity on the right. Above the first dividing line are the
current accounts—current assets and current liabilities—and each of these is subdivided into a permanent and a temporary component.
capital—the level of
working capital required at
all times Permanent working capital is the base level of working capital, the amount required independent of daily, seasonal, or cyclical variations in business activity.
It is made up of permanent current assets and permanent current liabilities. The
firm needs its permanent working capital on a continuous basis. Even though a
company’s cash, accounts receivable, inventory, etc. turn over more frequently
than once per year, and therefore are considered current assets by accounting,
there will be some minimum level of each of these resources required at all times.
It is impossible to operate without cash for liquidity. Extending trade credit, hence
creating accounts receivable and payable, is normal practice in most industries.
Some amount of inventory is a requirement for both merchandising and manu1 Elaboration: An alternative usage is to let working capital equal only a firm’s current assets and use
the term net working capital to represent current assets minus current liabilities. Chapter 12 Investing in Permanent Working Capital Assets 289 FIGURE 12.1
Levels of assets and
claims across time for a
growing firm. Current
assets and liabilities can
be divided into a
permanent level plus
temporary fluctuations. facturing. Therefore, even though permanent working capital appears on the accounting books in the current accounts, which suggests that it is short-term in nature, it is really a long-term requirement.
working capital due to
fluctuations in business
activity Temporary working capital is the amount above the base level which results from
variations in business activity. It is caused by three simultaneous processes. First,
the business cycle increases and decreases the resource needs of all businesses
over a multiyear time period. Second, most firms are seasonal, having an annual
cycle of activities. Third, daily events impact resource needs since revenues and
expenses, and cash inflows and outflows, rarely balance on a day-to-day basis.
Receivables and collections follow the pattern of sales. Expenses and payments,
on the other hand, are often tied to the day of the month. In contrast to permanent working capital, temporary working capital is short-term in nature. Organizing and Analyzing Permanent Working
Decisions about the level of permanent working capital are made in the same way
as capital budgeting decisions—we identify incremental cash flows, organize them
using a cash flow spreadsheet, and apply time value of money analysis. There is
only one difference between the two analyses, and it is minor: while plant and
equipment have a finite life, working capital can be around for the entire life of
an organization. Whenever we do not know how long the change will continue,
we make the assumption that the company is a “going concern” with infinite life. 1. Cash Flow Spreadsheet for Permanent
Working Capital Decisions
Figure 12.2 is a generic cash flow spreadsheet for permanent working capital. Notice that it is identical to the cash flow spreadsheets we used for capital budgeting 2 except that there is no column for “year n,” the last year of the investment’s life. Rather, the right-hand column is labeled “years 1– ,” representing all
271. The cash flow spreadsheet for capital budgeting decisions was introduced on page 290 Part IV Adding Value FIGURE 12.2
Cash flow spreadsheet
for permanent working
capital decisions. The
right-hand column is
labeled “Years 1– ”
since these changes
often have an
indeterminate life. Year 0
Operating cash flows
Net cash flows Years 1– (Cost) or recovery
Tax on above years from the first year of change to the end of the company’s existence. As with
the spreadsheet for capital budgeting, this column would have to be separated
into several columns if the cash flows from the proposed change differed from
year to year. This simplified spreadsheet is intended to illustrate the form of permanent working capital decisions; we will provide more detail as we examine
specific working capital items later in this chapter.
Because changes to permanent working capital are treated as having an indefinite life, the appropriate time value model to apply to the ongoing cash flows is
the perpetuity (perpetual annuity) model.3 Recall that for a perpetuity:
r and, rearranging the algebra, the interest rate embedded in a perpetuity, which
for a permanent working capital decision is the internal rate of return, is:
PV The Value of Permanent Working Capital Cash Flows
A proposed change to permanent working capital promises the following cash
Operating cash flow
Net cash flows Years 1– ($50,000)
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