Chapter 16 - Capital Budgeting - Overview and relevant cash flows PDF

# Chapter 16: Capital Budgeting - Overview and Relevant Cash Flows ## Finance Snapshot **Capital Budgeting - Overview and Relevant Cash Flows** The first step in a capital budgeting process is gathering both quantitative and qualitative information regarding potential project investments. Once the...

# Chapter 16: Capital Budgeting - Overview and Relevant Cash Flows ## Finance Snapshot **Capital Budgeting - Overview and Relevant Cash Flows** The first step in a capital budgeting process is gathering both quantitative and qualitative information regarding potential project investments. Once the available information is gathered, the next step is identifying and calculating the cash flows included in the capital budget analysis and determining the appropriate discount rate to apply. ## Capital Budgeting Overview * **Capital expenditures** can take many forms, including: * Expand or improve operating activities * Replace or relocate operating capacity * Form or acquire new subsidiary companies * Develop a technology (for example, for a new product) * The **capital budgeting process** typically involves three administrative areas: * Project generation * Project approval * Project follow-up ### Types of Cash Flows * **Initial investment** * Capital expenditures * Opportunity costs * Tax benefits arising from the initial investments, including CCA tax shield * **After-tax operating cash flows** * Incremental revenues * Incremental fixed costs * Incremental variable costs * Tax effects of incremental revenues and costs * **Working capital** * Increases in working capital * Reduction of working capital at the end of the project * **Salvage values** * Sale or disposal of assets (including proceeds and related costs) * Tax effects, including any loss of CCA tax shield ## Relevant Cash Flows Most project investments are expected to generate cash flows over several future time periods. To evaluate a project, all expected cash flows of the life of the project are needed and in what time period they will occur. The analysis should focus on the incremental cash flows - that is, cash flows directly attributable to investing in the project. All cash flows are calculated on an after-tax basis for capital budgeting purposes. ## Tax Shields Canadian income tax rules allow for the deduction of capital cost allowance (CCA). When determining the capital investment or disposition impact for capital assets, it is important to consider the impact of CCA. ## Cash Flow Considerations When preparing cash flows, it is important to be aware of sunk costs and side effects. Sunk costs are costs that are already incurred before making the decision. As a result, they are not incremental to the analysis and should not be included. Side effects are positive or negative impacts on other parts of the business arising from the investment or project. ## Inflation Inflation should be included in the calculation of cash flows. It is important to determine an accurate inflation rate for each of the elements in the cash flow. ## Relevant Discount Rate The right discount rate needs to be determined based on the risk level of a project. All else being equal, a riskier project should have a higher discount rate and a less risky project a lower discount rate. # Lesson 1: The Capital Budgeting Process and Cash Flows Related to the Initial Capital Investment ## Technical Competency: * 5.3.1 Develops or evaluates capital budgeting processes and decisions ## Learning Outcomes: * Explain the overall capital budgeting process * Identify and calculate the costs of initial investments, including opportunity cost. * Calculate the present value of the tax benefit related to the asset investment. # 16.1 Capital Budgeting - Overview Capital expenditures can take many forms and can be used, among other things, to accomplish any of the following strategic objectives: * Expand or improve operating activities * Replace or relocate operating capacity * Form or acquire new subsidiary companies * Develop a technology (for example, for a new product) No matter what the capital expenditure is used for, the firm must evaluate these decisions with due care. Given their size and importance for future profitability, much depends on these decisions. The right decision can help improve long-term profitability and sustainability, while the wrong decision may have a lasting detrimental impact on the firm's performance or even prove fatal to the firm. # 16.2 Capital Budgeting Process Given the risk associated with capital budgeting decisions, most corporations recognize the need for, and benefits of, having highly structured capital budgeting procedures that are designed to minimize errors and ensure a thorough analysis. Typically, this process involves the following three administrative areas: 1. **Project generation:** * Innovation and sensitivity to consumer needs are critical considerations when generating new projects. * Increased future profitability arises from identifying a market niche (thus creating a competitive advantage) using innovative cost-reduction initiatives, and/or creating barriers to entry to reduce competition. 2. **Project approval:** * Projects need significant expenditures and, therefore, require a formal capital budgeting request. Which person or group within the organization is responsible for approving these requests typically depends on the size of the expenditure and the size and importance of the project: * **Top management** typically approves large projects and projects outside the firm's current scope of business. * **Middle or lower management** can often approve small projects or projects within the firm's existing scope of business. * Each project request must come with detailed cash flow estimates and other relevant information. * The company's executive (ultimately the responsible party for capital budgeting decisions) then considers not only the economic merits of the proposal but also the broader set of related issues, such as: * non-economic implications of the project * potential conflicts between various project requests * total funding needed for all accepted projects 3. **Project follow-up:** * The executives typically approve and monitor all the project’s major expenditures. * With the regular reporting of cash flows, the executives can see whether the original cash flow estimates (submitted with the capital budgeting request) are accurate. By comparing estimated (budgeted) and actual cash flows, the executives can see discrepancies as they arise and can respond in a timely manner. In addition, the executives can also identify divisions that are consistently overly optimistic or overly conservative in their capital budgeting forecasts and factor this into future capital budgeting approvals. * Follow-up procedures, in addition to fostering thoroughness, are also designed to reduce conflicts of interest. Divisional managers may want to pursue projects that are not in the shareholders’ best interest. For example, divisional managers may want to expand their own divisions and thereby their stature within the company, even when the funds would be better invested in the projects of other divisions that could contribute more to the overall wealth of the firm. A divisional manager could also attempt to gain extra resources by providing cash flow estimates that are consistently overly optimistic (as in the previous bullet). The company’s follow-up procedures will reduce this problem by ensuring a full investigation of the results of a project. ## The Major Types of Information and Methods Used for Capital Budgeting Decisions* The following diagram summarizes the major types of information and methods used for capital budgeting decisions. Relevant quantitative information includes a project’s expected cash inflows and outflows (financial benefits). In addition, for some of the methods of analysis, an appropriate discount rate must also be determined. * **Quantitative Analysis** * Relevant Cash Flows * Relevant Discount Rate * **Qualitative Analysis** * Relevant Qualitative Factors * **Choose Appropriate Quantitative(s)** * Net Present Value * Internal Rate of Return * Payback Period (Undiscounted or Discounted) * **Test Assumptions** * Sensitivity Analysis ## 16.3 Relevant Cash Flows Potential project investments are expected to generate cash flows over several future time periods. Thus, the first step in capital budgeting is to identify and create a schedule over the time period of all expected cash inflows and outflows that are relevant to the potential project investment. Only the incremental cash flows are relevant, and therefore included, in any capital budgeting analysis - that is, the change in cash inflows and outflows directly attributable to investing in the project. ## 16.3.1 Time Frame of the Project and Building the Spreadsheet The first consideration when gathering relevant cash flow information is to determine the time frame for the project. This might be based on the useful life of the asset, the term of a contract, or perpetuity in the case of investing in a new line of business or an intangible asset that has an indefinite life. The information is usually summarized in a spreadsheet, with each column representing a specific time period (such as the month or year), including Time (or Year) when the initial investment will take place. Positive cash flows are entered as positive numbers and negative cash flows as negative numbers. The Net Present Value chapter provides greater detail on how the spreadsheet is set up and how cash flows are entered. ## 16.4 Categories of Cash Flows When assessing the incremental cash flows, there are four general categories considered for each capital project: * **Initial investment** * Capital expenditures * Opportunity costs * Tax benefits arising from the initial investments, including CCA tax shield * **After-tax operating cash flows** * Incremental revenues * Incremental fixed costs * Incremental variable costs * Tax effects of incremental revenues and costs * **Working capital** * Increases in working capital * Reduction of working capital at the end of project * **Salvage values** * Sale or disposal of assets (including proceeds and related costs) * Tax effects, including any loss of CCA tax shield These cash flow categories will be examined in detail below. One key point to remember is that all cash flows are calculated on an after-tax basis for capital budgeting purposes. Financing costs related to the source of financing are not included in the cash flows for the capital budget because the financing decision is separate from the capital budgeting decision. This distinction is addressed in Section 16.7. ## 16.5 Initial Investment Costs The initial investment in a project will include all incremental capital expenditures. These cash outflows usually occur at Time O (the present time), but in some cases, may extend over more than one period. For example, construction of a building might take two to three years to complete. ### 16.5.1 Opportunity Costs If a new capital project involves the use of existing assets, the opportunity cost of converting those assets to the new capital project must be considered. Opportunity costs are forgone benefits from choosing one alternative over the next best alternative; in other words, the benefits that are given up if an asset is used for the new project instead of for its existing use. If the asset is currently being used, then its opportunity cost is the current value-in-use (after tax) to the company. If an asset is currently unused, it can likely be sold in which case the value of the proceeds of sale (after tax) are given up if used for the new project instead of being sold. Note that neither the original cost nor the book value of assets is relevant for this analysis. ## 16.6 Tax Benefits from Capital Asset Investments The tax benefits arising from the investment made in a capital asset must also be considered. Under Canadian income tax rules, assets qualify for a specific capital cost allowance (CCA) class that stipulates the rate of CCA that may be deducted each year for calculating taxable income. CCA is a deduction for income tax purposes and therefore results in a tax benefit (savings). CCA rates reflect the estimated usage of the types of assets in each class. From a tax perspective, individual assets are viewed as part of an asset pool where assets in each class are combined. CCA amounts each year are based on the remaining balance in the pool. This remaining balance is called the undepreciated capital cost (UCC) balance. As long as at least one asset remains in the asset pool, CCA can continue to be deducted. The UCC pool increases in any given year by the amount of net acquisitions (acquisitions minus disposals) and decreases by the amount of CCA that is taken. Note that a company can take anywhere between 0% and the maximum rate allowed for the asset class. This means that if the company suffers a loss, it can elect not to take the CCA in that year and instead save the deduction for future years when it expects to be profitable. There are two methods to calculate the impact of these tax savings for capital budgeting purposes: 1. CCA deduction taken as part of the operating cash flows: In this method, the CCA claim related to the new capital assets is deducted each time period from the operating cash flows. Income tax is calculated on this net amount, and then the CCA is added back to arrive at net operating after-tax cash flows. The tax benefit of the CCA is captured with a lower income tax expense. 2. Present value of the tax shield on CCA: To simplify the calculation of the present value (PV) of the total (infinite) tax shield from CCA, a formula can be used, known as the present value of the tax shield on CCA formula (tax shield formula). This formula calculates the PV of all the future tax savings arising from the maximum annual CCA deduction claims allowed for the asset. This formula can only be used for assets that qualify for CCA classes where the CCA is calculated on a declining balance. The formula for the PV of the CCA tax shield will vary depending on how CCA can be claimed on the assets in the year of acquisition. The following sections look at three different scenarios. ### 16.6.1 Assets that Qualify for the Half-Year CCA in the Initial Year The formula is as follows: $$ PV of the tax shield on CCA = \frac{Investment × CCA rate × corporate tax rate}{CCA rate + discount rate} × \frac{1 + 0.5 × discount rate}{1 + discount rate} $$ When firms acquire an asset, in the initial year of use, they can only apply one-half of the CCA rate to the net acquisitions in an asset class. This adjustment is called the half-year rule. Note that the second component of the formula ([1 + (0.5 x discount rate)] / (1 + discount rate)} is used to adjust for the half-year rule in the year of acquisition - that is, in the year of acquisition, only one-half the amount of the CCA can be claimed ### 16.6.2 Assets that Qualify for the Accelerated Investment Incentive(All) The All applies to "accelerated investment incentive property" acquired after November 20, 2018, and available for use before 2028. The All allows companies to deduct 1.5 times the CCA rate in the year the asset becomes available for use. The PV of the tax shield formula for assets eligible for the All is as follows: $$ PV of the tax shield on CCA= \frac{Investment × CCA rate × corporate tax rate}{CCA rate + discount rate} × \frac{1.5 × discount rate}{1 + discount rate} $$ Note that the only difference with the earlier formula is that it is 1.5 times the discount rate, rather than one-half the discount rate. ### 16.6.3 Assets that Qualify for the Temporary 100% Deduction In the 2021 federal budget, a temporary measure was proposed that would provide Canadian-controlled private corporations (CCPCs) with a 100% CCA deduction in the year of purchase for eligible property in CCA classes other than 1 to 6, 14.1, 17, 47, 49, and 51, as these classes are generally long-lived assets. Assets qualify if they are acquired on or after April 19, 2021, (budget day, 2021) and put into use before January 1, 2024. This measure is only available to a maximum of $1.5 million per year and no carry-forward is permitted. The revised PV of the tax shield on CCA formula for assets that qualify for this temporary CCA rule is as follows: $$ PV of the tax shield on CCA = \frac{Investment × corporate tax rate}{1 + discount rate} $$ In this case, the tax shield formula is not used since there are no future CCA deductions available (assuming the acquisition cost is less than $1.5 million). Since this benefit will be realized in the first year of use, it is discounted by one year as shown above. The following sections look at the details of the calculations for each of these scenarios. #### 16.6.3.1 Investment Qualifies for 20% CCA and Half-Year Rule A new machine is purchased by Bedford Inc. for $175,000 and its applicable CCA rate is 20%, with 50% of the normal CCA allowed in the first year of use (that is, the half-year rule is applied for CCA in its first year). Bedford’s tax rate is 26%. Bedford has a cost of capital of 14% for this project. First is an example of how the annual CCA amount is calculated. **1. Annual CCA Deduction and Calculation of the Tax Benefit Related to the CCA Deduction** |**Year 1**|**Year 2**|**Year 3**| |:---:|:---:|:---:| |Opening UCC|$0|$157,500|$126,000| |New investment|$175,000|$0|$0| |CCA|($17,500) |($31,500) |($25,200)| |Closing UCC|$157,500|$126,000|$100,800| |Annual tax benefit at 26% tax rate = CCA × 26%|$4,550|$8,190|$6,552| |=$17,500 × 26%|$31,500 × 26%|$25,200 × 26%| The CCA continues to be calculated until there is nothing left in this class, so the company can continue to benefit from the CCA tax shield on this equipment indefinitely although at a declining rate (assuming that the asset class pool has at least one asset in it). The Capital Budgeting - The Investment Decision chapter will demonstrate how the CCA deduction and tax benefit are incorporated into the calculation of the annual cash flows for the capital budget analysis. Each year will be appropriately discounted to determine the PV of the tax benefit. **2. Using the PV of tax shield on CCA for assets that have one-half the CCA claimed in the initial year** Use the same facts as above: a new machine is purchased by Bedford Inc. for $175,000 and its applicable CCA rate is 20%, with 50% CCA allowed in the first year of use in Year 1 (that is, the half-year rule is applied for CCA in its first year). Bedford’s tax rate is 26%. Bedford has a cost of capital of 14% for this project. $$ PV of the tax shield on CCA = \frac{Investment × CCA rate × corporate tax rate}{CCA rate + discount rate} × \frac{1 + 0.5 × discount rate}{1 + discount rate} $$ $$ PV of tax shield on CCA = \frac{175,000(0.20)(0.26) × (1 + (0.5 × 0.14))}{0.20 + 0.14} × \frac{1 + 0.14}{1 + 0.14} = \$25,121 $$ Note that this figure of $25,121 represents the PV of the total CCA tax shield that the company will benefit from if it purchases the machine. Note also that these benefits exceed those realized during the first three years (the planning horizon) because, as explained, the residual benefits will continue as long as the firm has assets in the class pool. This CCA tax shield represents an inflow of cash because it is a tax savings resulting from the deduction of the CCA. #### 16.6.3.2 Investment Qualifies for the All A new machine is purchased by Azarus Inc. for $450,000 and its applicable CCA rate is 30%, with 150% of the normal CCA allowed in the first year of use. Azarus’s tax rate is 26% and its cost of capital is 12% for this project. $$ PV of the tax shield on CCA = \frac{Investment × CCA rate × corporate tax rate}{CCA rate + discount rate} × \frac{1 + 1.5 × discount rate}{1 + discount rate} $$ $$ PV of tax shield on CCA= \frac{450,000(0.30)(0.26) × (1 + (1.5 × 0.12))}{0.30 + 0.12} × \frac{1 + 0.12}{1 + 0.12} = \$88,048 $$ #### 16.6.3.3 Investment Qualifies for Full Expensing in the Year of Acquisition<br>  Landson Inc. purchases a machine for $500,000 that qualifies for 100% full deduction for CCA purposes. Landson’s tax rate is 15%. Landson has a cost of capital of 10% for this project. Since the full amount can be totally expensed, the CCA amount (assuming this is the first year of use) is $500,000. The PV of this tax benefit is calculated as follows: $$ PV of the tax shield on CCA = \frac{Investment × corporate tax rate}{1 + discount rate} $$ $$ PV of the tax shield on CCA = \frac{500,000 × 15%}{1 + 10%} = \$68,182 $$ A net present value analysis using both the tax shield approach and the CCA deduction approach are demonstrated in the Capital Budgeting - The Investment Decision chapter. ## 16.6a Let’s Look at an Example For an upcoming project, a company will make an investment of $600,000 in equipment qualifying for 20% declining balance CCA and 50% of the CCA in the first year of use (half-year rule). The company’s income tax rate is 25% and the discount rate appropriate for this project is 12%. Required: * Using the tax shield formula, calculate the of all the future tax savings to be derived from the CCA claim on this equipment. Solution $$ PV of the tax shield on CCA = \frac{Investment × CCA rate × corporate tax rate}{CCA rate + discount rate} × \frac{1 + 1.5 × discount rate}{1 + discount rate} $$ $$ PV of the tax shield on CCA = \frac{600,000 × 0.20 × 0.25 × (1 + (0.5 × 0.12))}{0.20 + 0.12} × \frac{1 + 0.12}{1 + 0.12} = \$88,728 $$ The $88,728 is the amount of the investment that will be recovered through future tax savings as a result of claiming the CCA. Consequently, the net cash investment over the project life related to the purchase of the equipment is: $600,000-$88,728 = $511,272. Note that the PV is calculated to the time of the original investment. ## 16.6b Let’s Look at an Example In early Year 1, Rocket Inc. is considering an investment in new equipment that will cost $850,000. The equipment qualifies for 30% declining balance CCA. The company’s income tax rate is 15% and the discount rate appropriate for this project is 9%. In the first year of use, 1.5 times the CCA can be claimed. Required: * Calculate the annual CCA deduction and tax benefit for each of the first three years, starting in Year 1. Solution |Year 1|Year 2|Year 3| |:---:|:---:|:---:| |Opening UCC|$0|$467,500|$327,250| |New investment|$850,000|$0|$0| |CCA|(-$182,500)|(-$140,250)|(-$98,175)| |=$850,000 × 30% × 1.5|$467,500 × 30%|$327,250 × 30%| |Closing UCC|$467,500|$327,250|$229,075| |Annual tax benefit at 26% tax rate = CCA x 15%|$57,375|$21,038|$14,726| |=$382,500 × 15%|$140,250 × 15%|$98,175 × 15%| ## 16.6c Let’s Look at an Example Spaxer Inc. is considering an investment in new equipment that will cost $650,000. The equipment qualifies for 100% full expensing in the first year of use. The company’s income tax rate is 15% and the discount rate appropriate for this project is 9%. Required: * Calculate the PV of the tax benefit due to CCA arising from this investment. Solution $$ PV of the tax shield on CCA = \frac{Investment × corporate tax rate}{1 + discount rate} $$ $$ PV of the tax shield on CCA = \frac{650,000 × 15%}{1 + 9%} = \$89,450 $$ ## 16.6d Let’s Look at an Example A new machine is purchased by Freazer Inc. for $1,150,000 plus installation costs of $50,000. The equipment qualifies for the CCA declining rate of 20% with 150% CCA allowed in the first year of use. Freazer’s tax rate is 27% and its cost of capital is 16% for this project. The installation is included in the capital costs and therefore the total costs = $1,150,000 + $50,000 = $1,200,000. $$ PV of the tax shield on CCA = \frac{Investment × CCA rate × corporate tax rate}{CCA rate + discount rate} × \frac{1 + 1.5 × discount rate}{1 + discount rate} $$ $$ PV of tax shield on CCA = \frac{1,200,000(0.20)(0.27) × (1 + (1.5 × 0.16))}{0.20 + 0.16} × \frac{1 + 0.16}{1 + 0.16} = \$192,414 $$ # E-Lesson: Tax Shield This e-lesson focuses on the impact taxes have on net present value calculations. # Lesson 2: Cash Flows Related to Operations, Working Capital, and Salvage Required for the Capital Budgeting Decision ## Technical Competency * 5.3.1 Develops or evaluates capital budgeting processes and decisions ## Learning Outcomes: * Identify and calculate the relevant cash flows related to a project * Explain what is meant by a sunk cost, a side effect, and working capital related to a capital project and how they are treated in the analysis * Calculate the after-tax operating cash flows related to a project * Calculate the amount of the tax benefit lost on salvage # 16.7 After-Tax Operating Cash Flows After-tax operating cash flows represent changes to revenues and operating costs specifically related to the project. The incremental cash flows might include increased sales, reduced variable or fixed costs, new variable or fixed costs, or any combination thereof. The net operating cash flows might be positive in some time periods and negative in others. Net operating cash flows are all calculated on an after-tax basis when evaluating a project. In addition to the direct increases in revenues and costs related to the project, there are other items to consider: * **Sunk costs** are costs that have already been incurred and are to be ignored in the project’s analysis. These costs are incurred before making the decision to proceed with the project and will be paid regardless of whether the project proceeds. Consequently, they are not incremental to the capital budget decision. Examples of operating sunk costs include consultants' reports as well as research and development costs that are incurred before the project analysis and might be the impetus to prepare a capital budget analysis. * **Side effects** are positive and negative impacts, represented by incidental increases (or decreases) in cash inflows, on other parts of the business arising from investment in the project. For instance, increases in net operating cash flows may arise for complementary products that will have higher future sales. Decreases in net operating cash flows may occur due to loss of sales for competing products. Side effects are included as relevant cash flows for the project since they are impacts on the business as a result of the project.  ## 16.7a Let’s Look at an Example As a result of a recent consultant’s report, Foquetten Inc. is assessing a project that would result in a new product line. The consultant will be paid $50,000 for this report next month. As part of the capital budget analysis, management has forecasted operating cash flows related to this new product. Revenues are estimated to be $2,500,000 for Year 1 and then $3,000,000 each year thereafter. Cost of goods sold are 35% of revenues, and selling costs will be $230,000 annually. In addition, it is expected that there will be lost sales of an existing product of $500,000 each year. Costs related to this existing product are 45% of revenues. Finally, the company will allocate head office costs of $100,000 annually, although there will be no increase in total head office costs. The project has a five-year life. Foquetten has an income tax rate of 26%. Required: * Determine the after-tax operating cash flows arising from this new product line to be used in the capital budget analysis. Solution The allocation of the head office costs is not an incremental cost and therefore is not included in the cash flows projected below. The lost net revenues for the existing product are a side effect of introducing the new product and must be included in the analysis since these are relevant incremental costs. Finally, the consultant report is a sunk cost since it must be paid regardless of whether the project is accepted or rejected. As such, the $50,000 is not included in the analysis. Below are the annual operating cash flows after tax that would be included in the new product line project’s capital budget analysis. |Year 1|Year 2|Year 3|Year 4|Year 5| |:---:|:---:|:---:|:---:|:---:| |New product revenue|$2,500,000|$3,000,000|$3,000,000|$3,000,000|$3,000,000| |New product - COGS (35% of revenues)|(-$875,000)|(-$1,050,000)|(-$1,050,000)|(-$1,050,000)|(-$1,050,000)| |New product selling costs|(-$230,000)|(-$230,000)|(-$230,000)|(-$230,000)|(-$230,000)| |Existing product lost revenues|(-$500,000)|(-$500,000)|(-$500,000)|(-$500,000)|(-$500,000)| |Existing product - costs (45% of revenues)|$225,000|$225,000|$225,000|$225,000|$225,000| |=$1,120,000|$1,445,000|$1,445,000|$1,445,000|$1,445,000| |Taxes at 26%|(-$291,200)|(-$375,700)|(-$375,700)|(-$375,700)|(-$375,700)| |Operating cash flows after tax|$828,800|$1,069,300|$1,069,300|$1,069,300|$1,069,300| # 16.8 Investment in Working Capital It is important to include working capital (also referred to as net working capita) effects in the capital budgeting analysis. Working capital represents the funds that a company has invested in current assets, such as accounts receivable and inventories, less current liabilities, which include accounts payable. Any changes in required working capital resulting from the project must be included in the analysis. Working capital increases often result from higher receivables and inventories. Part of this investment may be offset with an increase in supplier payables, but the company must still invest in the net change in working capital. For example, if a new store is opened, inventory is needed to stock it. This one-time investment must occur at Time O (assuming full operations begin at that time). On the other hand, the investment in accounts receivable does not occur until after sales are made to customers on account. Although this investment does not occur exactly at Time O, it tends to be closer to Time O than to the end of the first time period (Time 1), especially if time periods are measured in years. Therefore, it is better to list this investment at Time O. Net of these current asset amounts are supplier payables. Accordingly, the company shows a net investment at Time O equal to the increase in inventories plus the increase in accounts receivable minus the increase in supplier payables. Remember that as sales increase over the life of the project, receivable and inventory balances typically also increase, causing incremental changes to the net working capital balances throughout the project's life. At the end of the project’s life, working capital returns to its original balance. The working capital investment is recovered as inventories are liquidated, accounts receivable are collected, and suppliers are paid. Note, as above, that this does not happen exactly at the end of the project life, but is close enough to the end of the project life that small differences will be immaterial. ## 16.8.1 Example: Working Capital Investment<br>  The following example shows how to calculate the balances required for investment in operating working capital over the life of a project in which time periods are measured in years. The change in the working capital balance represents a cash flow for the capital budget analysis. An increase in working capital represents a cash outflow for the capital budget analysis, while a reduction in working capital represents a cash inflow. This is evident in the example below. |Inception|Year 1 |Year 2 |Year 3 |Year 4 |Year 5 | |:---:|:---:|:---:|:---:|:---:|:---:| |Time O|$|$|$|$|$ |Accounts receivable|$10,000|$12,000|$13,000|$|$|$ |Inventories|$3,000|$3,500|$4,000|$|$|$ |Accounts payable|(-$6,000)|(-$6,200)|(-$6,300)| |Net working capital balance |$7,000|$9,300|$10,700|$|$|$ |Opening balance|(-$7,000)|(-$9,300)|(-$10,700)| |Change in working capital|$7,000|$2,300|$1,400|$|$|$ |Investment required in working capital|(-$7,000)|(-$2,300)|$1,400|$|$|$ A company has forecast the balances of receivables, inventories, and payables throughout the life of a project, as shown above. The net investment in working capital is the net amount of the balances of receivables plus inventories less payables. The net investment in working capital is initially $7,000 at Time O (which is now), then $9,300 in Year 1 and $10,700 in Year 2. At the end of Year 3, the project’s life is completed - all the inventories are sold, receivables collected, and suppliers paid, so the net balance is now $0. The cash flows