Working capital and capital budgeting. Working capital investment is 25% of the

Question

Working capital and capital budgeting. Working capital investment is 25% of the anticipated first year sales for Wally’s Waffle House. The first-year sales are currently projected at $4,300,000. The incremental cash flow (not including working capital investment) is Initial cash flow = $13,700,000 outflow Cash flow years 1 through 10 = $2,850,000 What is the internal rate of return of the ten-year project with working capital factored into the cash flow? What is the net present value at a 15% weighted average cost of capital? What is the maximum investment in working capital for an acceptable project with a 15% weighted average cost of capital?

Explanation / Answer

Initial working capital needed = $ 4,300,000 x 25% = $ 1,075,000

Total initial investment required = $ ( 13,700,000 + 1,075,000) = $ 14,775,000

Computation of internal rate of return:

PV factor = Initial investment/ Annual cash flows = 14,775,000 / 2,850,000 = 5.1842

Consulting the PVA table row for 10 years, the closest discount rate is 14.2%

Computation of Net Present Value (NPV) :

NPV at 15% discount rate = Present value of cash inflows - Initial investment

Present value of cash inflows = 2,850,000 x PVIFA 15%, n=10 = 2,850,000 x 5.0188 = $ 14,303,580

NPV = $ ( 14,303,580 - 14,775,000) = $ ( 471,420)

The maximum investment in working capital = $ ( 14,303,580 - 13,700,000) = $ 603,580

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