Introductory Corporate Finance: Cash Flow Estimation - Net Working, Capital NWC Changes Initial Investment Recovery at End

What This Is

Net Working Capital (NWC) changes refer to the fluctuations in a company's current assets and current liabilities over time. This concept is crucial in corporate finance as it affects a company's ability to meet its short-term obligations and generate cash flow. For instance, consider Tesla, which has experienced rapid growth in recent years. In 2020, Tesla's current assets increased by $10 billion, while its current liabilities increased by $5 billion. This resulted in a net increase in NWC of $5 billion, which helped the company to meet its short-term obligations and invest in new projects.

Key Formulas & Models

• NWC = CA - CL – net working capital; represents the difference between current assets and current liabilities.
  • CA: current assets (e.g., cash, accounts receivable, inventory)
  • CL: current liabilities (e.g., accounts payable, short-term debt)
• ?NWC = ?CA - ?CL – change in net working capital; represents the change in NWC over time.
  • ?CA: change in current assets
  • ?CL: change in current liabilities
• Initial Investment = ?NWC + Recovery at End – initial investment; represents the initial outlay required to invest in a project.
  • ?NWC: change in NWC
  • Recovery at End: the amount recovered at the end of the project
• Recovery at End = (1 - g) / (r - g) × ?NWC – recovery at end; represents the amount recovered at the end of the project.
  • g: growth rate
  • r: discount rate
• g = ROE × (1 - b) – sustainable growth rate; represents the maximum rate at which a company can grow without external financing.
  • ROE: return on equity
  • b: retention ratio
• r = WACC – discount rate; represents the weighted average cost of capital.
  • WACC: weighted average cost of capital
• WACC = wd × rd(1 - T) + wps × rps + we × re – weighted average cost of capital; used as discount rate.
  • wd: weight of debt
  • rd: cost of debt
  • T: tax rate
  • wps: weight of preferred stock
  • rps: cost of preferred stock
  • we: weight of equity
  • re: cost of equity

Step-by-Step Calculation

1. Calculate the change in net working capital (?NWC) by subtracting the change in current liabilities (?CL) from the change in current assets (?CA).
2. Calculate the initial investment by adding the change in net working capital (?NWC) to the recovery at end.
3. Calculate the recovery at end by dividing the change in net working capital (?NWC) by the difference between the discount rate (r) and the growth rate (g).
4. Calculate the sustainable growth rate (g) by multiplying the return on equity (ROE) by the retention ratio (1 - b).
5. Calculate the discount rate (r) by using the weighted average cost of capital (WACC).

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
  • Correction: Use market value for WACC to reflect the current market conditions.
  • Counterexample: Suppose a company has a book value of $100 million and a market value of $150 million. Using book value for WACC would result in a WACC of 10%, while using market value would result in a WACC of 8%.
• Mistake: Ignoring flotation costs.
  • Correction: Include flotation costs in the initial investment to reflect the actual cost of raising capital.
  • Counterexample: Suppose a company raises $100 million by issuing debt, but incurs flotation costs of $5 million. The initial investment would be $105 million, not $100 million.
• Mistake: Confusing sunk cost with opportunity cost.
  • Correction: Use opportunity cost instead of sunk cost to reflect the value of the next best alternative.
  • Counterexample: Suppose a company invests $100 million in a project, but the opportunity cost is $120 million. The opportunity cost is the correct measure of the cost of the project.

Exam / CFA Tips

• Tip: Be careful when using the M&M Proposition I (no taxes) and M&M Proposition II (with taxes) to calculate the cost of capital.
  • Trick: Remember that the M&M Proposition I assumes no taxes, while the M&M Proposition II assumes taxes.
• Tip: Be careful when using the degree of operating leverage (DOL) to measure the sensitivity of EBIT to sales.
  • Trick: Remember that the DOL is calculated as Q(P - V) / (Q(P - V) - F), where Q is the quantity sold, P is the price per unit, V is the variable cost per unit, and F is the fixed cost.
• Tip: Be careful when using the sustainable growth rate (g) to calculate the maximum rate at which a company can grow without external financing.
  • Trick: Remember that the sustainable growth rate is calculated as ROE × (1 - b), where ROE is the return on equity and b is the retention ratio.

Quick Practice Problem

A company has EBIT of $10 million, interest of $2 million, and tax of 25%. Calculate the degree of financial leverage (DFL).

Answer: DFL = (EBIT + Interest) / EBIT = ($12 million) / ($10 million) = 1.2

Explanation: The DFL is calculated by dividing the sum of EBIT and interest by EBIT.

Last-Minute Cram Sheet

• NWC = CA - CL – net working capital
• ?NWC = ?CA - ?CL – change in net working capital
• Initial Investment = ?NWC + Recovery at End – initial investment
• Recovery at End = (1 - g) / (r - g) × ?NWC – recovery at end
• g = ROE × (1 - b) – sustainable growth rate
• r = WACC – discount rate
• WACC = wd × rd(1 - T) + wps × rps + we × re – weighted average cost of capital
• DOL = Q(P - V) / (Q(P - V) - F) – degree of operating leverage
• DFL = (EBIT + Interest) / EBIT – degree of financial leverage
• In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield