When evaluating a new project investment, analyzing the net working capital requirements and recovery is crucial. The net working capital invested in starting up a project represents funds tied up in inventory, accounts receivable less accounts payable. This capital investment acts like a short-term loan to the project. Generally, the initial net working capital will be recovered towards the end of the project life cycle through the sale of inventories, collection of receivables and payment of payables. Understanding the working capital cash flow pattern can improve capital budgeting analysis and investment decision making.
Project working capital investment follows a flow pattern of initial outlay followed by eventual recovery
The net working capital invested in a project typically follows a pattern of initial cash outflow as investment to fund startup inventory, accounts receivable and other current assets. This is followed by the eventual recovery of the invested funds towards the project closing or termination stages. Analyzing and projecting this working capital cash flow pattern improves the accuracy of capital budgeting metrics like NPV.
Failure to account for net working capital may overstate project cash flows and returns
A common mistake is to omit net working capital investment requirements and recovery while projecting cash inflows like revenue and outflows like costs. This leads to overstating the net cash flows and inflated returns for the project. Correctly incorporating the timing and amounts of incremental working capital in the analysis provides better estimate.
Working capital recovery frees up capital for investment in new projects
Rather than an expense, the recovery of previously invested working capital should be viewed as a cash inflow to the firm. The freed up capital can then be deployed into new investments and business expansion, instead of being stuck in the closing project. Planning for efficient working capital recovery is therefore vital.
Both initial investment and eventual recovery carry an opportunity cost for the firm
The working capital requirements of the new project represent capital that could have been otherwise invested immediately rather an being tied up in the project. Similarly, faster working capital recovery means capital availability sooner for alternative deployment. Analyzing this opportunity cost and time value of capital enhances project selection decisions.
In summary, incorrectly ignoring the initial net working capital investment and eventual recovery in capital budgeting analysis of projects can provide misleading results. The outflow, inflow and opportunity cost of project working capital are vital considerations for accurate investment decision making and maximizing firm value over time.