Treatment of Working Capital in Investment Analysis - Part I

Teemu Aho and Ilkka Virtanen

English summary

This paper deals with the treatment of working capital in calculating the present value of an investment. Working capital can be considered either on costs basis or payment basis. Both methods result in the same present value of working capital investment, which in non-inflationary case is the product of the discount rate and the present value factor for uniform annual payments multiplied by the amount of working capital investment.

Under inflationary circumstances the present value calculations can be made either on money terms or real terms. The term ³money² is used when the actual amount is referred to. The term ³real² is used when the effects of inflation on the actual amount have been removed. Working capital can still be considered either on costs basis or payment basis. In this research all four ways in considering working capital/inflation resulted in the same real present value. Inflation in itself worsened the real present value of working capital investment, which was due to a continuously increasing need for working capital. When working capital increases were put at the beginning of the year inflation worsened the real present value of a working capital investment by -((1 + i)/i) 100 s per cent, where i is the real discount rate and s is the rate of inflation. The above formula was originally derived for the case of stable working capital volume. However at the end of the present paper it is shown that the relative worsening of the present value of working capital investment was also equal for the volume increases in working capital.

In a later article we shall be dealing with the handling of working capital in the context of annuity method, IRR and payback.

(The Finnish Journal of Business Economics 3-1982, 255-278)