HARD QUESTION (expert level) difference, budgeting, investment, valuation, between

badonkus

Ok guys, no peeking at notes here. This took me a while to figure out. Maybe y'all experts know this, but I consider this expert level.


Q. Tell me the difference between calculating Net Working Capital investment in capital budgeting and calculating Working Capital investment in Free Cash Flow valuation modeling. (there IS a difference, albeit slight)

KungFuPanda

No it's not. From your quote:

"... working capital for CASH FLOW and VALUATION purposes is defined to exclude cash and short-term debt (which includes notes payable and the current portion of long-term debt)."

Find me an example from the book or Schweser where Capital Budgeting/FCFE valuation NWCInv includes Cash and Short Term Debt and I'll shut up. I'm not arguing with what you said, but for the purpose of the exam everything you deal with is a cash flow, and therefore does not include cash/short term debt.

SeanWest

great thanks! i love this forum for keeping the stuff present in my head!

kkn006

Should point out that when working on capital budingeting decisions you are dealing with AFTER TAX CASH FLOWS. Therefore, the NWCInv you use DOES NOT include cash or short-term debt.

To summarize, you do NOT include Cash or Short Term Debt in your NWCInc calculation for FCFE or Capital Budgeting.

profil

That's wrong jdane416. See above, my quote from the CFA textbooks.

troymo

Correct, yella, for capital budgeting it's simple: CA - CL.

Let me type in verbatim CFAI Volume IV page 385:
"Although working capital is often defined as current assets minus current liabilities, working capital for cash flow and valuation purposes is defined to exclude cash and short-term debt (which includes notes payable and the current portion of long-term debt). When finding the net increase in working capital for the purpose of calculating free cash flow, we define working capital to exclude cash and cash equivalents as well as notes payable and the current portion of long-term debt. Cash and cash equivalents are excluded because a change in cash is what we are trying to explain. Notes payable and the current portion of long-term debt are excluded because they are liabilities with explicit interest costs that make them financing items rather than operating items." (pg. 386 Reading 41: Free Cash Flow Valuation)

Hope this helps. I think it's rather important not to confuse the two fomulae.

Best in June!

YAhmed

It all makes a lot of sense.

In capital budgeting you are trying to figure out what needs to go in and how much you'll get back, so cash going in will be an important factor.

In FCF calculations you are trying to understand how much cash the company has been able to generate.

So, (although counterintuitive) you cannot include changes in cash as it is what the rest of the forumla strives to explain (those changes in cash that result from operations will be accounted for by the rest of the formula).

Although short term debt and repayments are valid uses of cash they should be left out for FCFF as they would gum up the works. For FCFE, you will be adding them back when you add back Net Borrowings...

yalo

Change in AR + Change in Inv - Change in AP = the NWCInv.

If NWCInv is negative, then it is a INFLOW of cash.

eoin

yeah i know that formula.but the question was the difference between the calculation of nwc in FCF analysis and capital budgeting

wizofoz

great handle