Question

Working Capital

In the NPV computations we see something called working capital. What is working capital? Why do we consider it in the NPV computation?

Answer 1

Working Capital is the excess of current assets over current liabilities. Current assets are the company's highly liquid sources which are used to meet the company's obligations that are due within the next one year.

Working capital is considered in the Net Present Value (NPV) Computation because of the following reasons:

NPV is the present value of the future cashflows. While arriving at the net cash flows after tax the changes in the working capital need to be added or substracted because -

a) Accounts receivables form a major part of current assets and increase in accounts receivable result in reduction in cash flows and decrease in accounts receivable results in increase in cash flows.

b) Similary, the closing stock also form part of current asset and increase in stock results in reduction in cashflow and reduction in closing stock results in increased cashflows.

c) The accounts payable which the company owe's to it's creditors is major component of current liablities. The increase in accounts payable results in increase in cash flow and decrease in accounts payable results in decrease in cashflow.

Since working capital is excess of current assets over current liabilities, an increase in working capital should be deducted from profits and a reduction in working capital should be added to profits to arrive at correct cashflows. In accounting terminology increase in working capital is an application of funds and decrease in working capital is a source of funds.

As working capital has direct impact on the cashflows, it is considered for NPV computaion.