Net Working Capital. In our capital budgeting examples, we assumed that a firm would recover all of the working capital it invested in a project. Is this a reasonable assumption? When might it not be valid?
The correct answer and explanation is :
Correct Answer:
The assumption that a firm will recover all of the working capital it invests in a project is generally reasonable but not always valid. There are situations where some or all of the working capital may not be fully recovered, particularly if the project is shut down unexpectedly, the business faces financial distress, or certain assets become obsolete or unsellable.
Explanation (300+ words):
In capital budgeting, net working capital (NWC) typically includes current assets (like inventory and accounts receivable) minus current liabilities (like accounts payable). It represents the short-term funds needed to support a project’s operations. When evaluating a project’s cash flows, it is common to assume that the initial investment in NWC will be recovered at the end of the project’s life.
This assumption is based on the idea that the project will wind down in an orderly manner, allowing the firm to collect receivables, sell off remaining inventory, and settle all short-term liabilities. Under these conditions, the working capital is returned to the firm and can be used elsewhere, effectively contributing a positive cash inflow at the project’s end.
However, there are scenarios where this assumption may not hold true:
- Project failure or sudden shutdown: If a project ends prematurely or fails, the company may be left with unsellable inventory or uncollectible receivables.
- Economic or market changes: A collapse in demand could reduce the value of inventory or make it obsolete.
- Industry-specific risks: In fast-changing industries (e.g., tech), components and goods may lose value quickly.
- Credit risks: If customers go bankrupt or default, accounts receivable may not be collected.
In such cases, the expected recovery of NWC is impaired, and this should be reflected in the project’s risk analysis and sensitivity assessments. Thus, while assuming full recovery of NWC is standard practice in project analysis, financial managers must remain cautious and consider realistic outcomes, especially for high-risk projects or industries.