Initial Investment Outlay

CFA Level II
#1

Hi all,

As we know, initial investment outlay includes change in net working capital except for cash and short-term debt. But I cant make it sense when look at accouting equation.

For example when we invest in new machine, apart from fix capital investment, we also need to increase the inventory (materials, tools …) preparing for the operation of such machine. We could buy more inventory by cash or on credit term.

* In case we buy more inventory by cash

Inventory increase => net working capital included IIO increase ( cash is not included here)

* In case buy more inventory on credit term

Inventory increase => Account Payable increase => Net working capital included in IIO does not change

In both cases, we see that we still have to invest but why the impact on IIO.

Please help me

#2

In both cases (by cash or by supplier credit) we count initial Net Working Capital as an initial investment outlay. So I don’t know why you say IIO changes in each case.

Remember that you are evaluating the profitability or economical viability of a project, so initial investment must always count for all assets necessary for the startup, despite a portion of it is temporally borrowed (supplier credit).

Financial debt is another whole different story. In capital budget we assume the whole project is financed with 100% equity because we want to know the project real profitability in isolation.

#3

Thank you

I mean: When we increase inventory, we increase account payable => no change in Net WC (as current Asset and Current Liability increase in the same amount) => No impact on IIO

I am confused that in such case we might not include the increase in inventory in IIO

#4
#5

The initial outlay is not financed by a payable, it is paid in cash. Thus, you have increase in NWC (as cash is part of net debt, not NWC).

#6

IIO is cash only based. When you purchase/increase an inventory, you increase AP, but subsequently decrease cash when you settle your supplier’s invoice. Thus is with negative prefix as cash outflow. Opposite happens when you sell an inventory.

#7

Thanks Flashback !

I think the way curriculum describes is so confusing. They also mentioned the short term payable here

“The investment in NWC is the net investment in short term assets required for the investment. This is investment in Account Receivables, Inventory needed, less short term payables generated by the project”.

#8

That’s straightforward. This is net change (delta) on short term assets. Cash position is excluded from this formula because WC net change causes cash inflow/outflow and that’s what interested you.

#9

Thanks Flashback

Please see the following example from schwser note

An analyst has collected the following information on a replacement project:

  • Purchase price of the new machine $8,000
  • Shipping and installation charge 2,000
  • Sale price of old machine 6,000
  • Book value of old machine 2,000
  • Inventory increase if the new machine is installed 3,000
  • Accounts payable increase if the new machine is installed 1,000
  • Marginal tax rate 25%

The initial cash flow is closest to: A. –$10,000. B. –$7,000. C. –$3,000. Initial cash outlay = FCInv + NWCInv – Sal0 + T(Sal0 – B0) = 10,000 + (3,000 – 1,000) – 6,000 + 0.25(6,000 – 2,000) = 7,000 This indicates an initial cash flow of –$7,000

For the abvoe example, we only include the part change in current asset (3000-1000 = 2000) which is not financed by account payables.

It means that only 2000 increase in current asset which is financed by cash is included in initial investment outlay.

Please advise if my understand is not accurate

Thank you much

#10

This is not the part change, this is a full change in net ST asset what is the same as a change in WC. Recall, changes in WC are changes in net short term asset - changes in short term liabilities excluding cash & equivalents. Furthermore, each asset position has its source of financing, thus is financed by AP account in this example.

  • Total Inventory Increase, value of purchasing an Inventory, $3000 in this example
  • Increase in liabilties (AP account), $1000 in this example

= ΔWC (Net changes in current asset what is exact change in WC).

Cash is just outlay but cash is always created by changes in particular BS positions.

#11

The rest of formula shows cash realized bz selling the old machine - taxes paid on difference in selling price deducted for its BV.

Thus entire formula shows the cash outlay for:

  • Cash paid for purchasing and installation of new machine + (cash generated by benefit of using new machine - costs of maintenance of new machine or whatelse) + (cash generated by selling the old machine - taxes paid on net earnings realized by selling the old machine)
#12

Simply, it means that changes in current asset relevant to changes in account payable is not included in IIO since it is not outflow ?

#13

It is all included as outflow or inflow on net basis, ΔWC = ΔA - ΔL.