Chapter 8 - Pearson Learning Solutions

CHAPTER 8 Capital Budgeting Cash Flows 335change in networking capitalThe difference between achange in current assets anda change in current liabilities.expenditure decisions. If a firm acquires new machinery to expand its levelof operations, it will experience an increase in levels of cash, accounts receivable,inventories, accounts payable, and accruals. These increases result from theneed for more cash to support expanded operations, more accounts receivableand inventories to support increased sales, and more accounts payable andaccruals to support increased outlays made to meet expanded product demand.As noted in Chapter 3, increases in cash, accounts receivable, and inventories areoutflows of cash, whereas increases in accounts payable and accruals are inflowsof cash.The difference between the change in current assets and the change in currentliabilities is the change in net working capital. Generally, current assets increaseby more than current liabilities, resulting in an increased investment in networking capital. This increased investment is treated as an initial outflow. If thechange in net working capital were negative, it would be shown as an initialinflow. The change in net working capital—regardless of whether it is an increaseor a decrease—is not taxable because it merely involves a net buildup or netreduction of current accounts.ExampleDanson Company, a metal products manufacturer, is contemplating expandingits operations. Financial analysts expect that the changes in current accountssummarized in Table 8.4 will occur and will be maintained over the life of theexpansion. Current assets are expected to increase by $22,000, and current liabilitiesare expected to increase by $9,000, resulting in a $13,000 increase in networking capital. In this case, the change will represent an increased net workingcapital investment and will be treated as a cash outflow in calculating the initialinvestment.Calculating the Initial InvestmentA variety of tax and other considerations enter into the initial investment calculation.The following example illustrates calculation of the initial investmentaccording to the format in Table 8.2.TABLE 8.4Calculation of Change in Net Working Capitalfor Danson Company2008935971Current accountChange in balanceCash $ 4,000Accounts receivable 10,000Inventories1 8,000(1) Current assets $22,000Accounts payable $ 7,000Accruals1 2,000(2) Current liabilities1 9,000Change in net working capital [(1)(2)] 1$13,000Principles of Managerial Finance, Brief Fifth Edition, by Lawrence J. Gitman. Copyright © 2009 by Lawrence J. Gitman. Published by Prentice Hall.