Secret Sauce says that “the real cash flow from net working is not equal to the change in real working capital, so nominal working capital cash flows must be converted to real cash flows using the inflation index”. I just don’t understand why that is. Can someone explain?
the cash flow of net working capital is composed of the actual flow plus the holding effect - a change created by holding that working capital
for some reason it still doesn’t click …
Facts: base year real WC and nominal WC are same lets say $100. Next year nominal WC = 140 Next year expected inflation = 20% Next year real WC = 140/1.2 = 116.67 Change in Working Capital (nominal) = 140 - 100 = $40 Change in Working Capital (real) = 116.67 - 100 = $16.67 (Is this the correct? answer is No) Reason: In the change in real WC formula there are two terms one is 116.67 which incorporates the effect of this year inflation but the other term 100 doesn’t. The term 100 incorporates the effect of inflation for previous year not this year. So we need to incorporate the effect of inflation for this year into the second term. Base year real working capital was $100 and since inflation with respect to base year is 20% the value of this working capital in real terms will further go down: So base year real working capital = 100/1.2 = 83.33 (As of this year, this can also be termed as holding effect) Now if we calculate the change = 116.67 - 83.33 = 33.33 Hope it clears up your doubt
that’s a great example. thanks, kabhii.
Real net working capital = change of real working capital + beginning NWC*(i/(1+i)) another way to remember this is the change in real NWC = change in norminal NWC/(1+i), when base year real NWC now, which is the beginning real NWC, has depreciated to NWC0/(1+i). So that the change is balanced.