Net present value (NPV) calculations should include the discounted value of changes in working capital. This treatment of working capital accounts for the project's additional short-term investments recouped at a later date.
What Is NPV?
NPV analysis is a method for calculating the net benefits of a project that generates current and future cash flows in terms of today’s dollars. In other words, NPV is commonly defined as the sum of discounted net cash flows over the life of the project. A positive NPV signifies a project that has net positive benefits after accounting for the time value of money. A negative NPV indicates the project will result in a loss for the investor. NPV analysis also provides a common basis for making capital budgeting decisions by comparing any number of projects irrespective of size, duration, or timing of cash flows.
What Is Working Capital?
When conducting NPV analysis, there are several considerations, one of which is the treatment of working capital. Working capital, or current assets minus current liabilities, is essentially financial resources available to a company for its day-to-day operations. Examples of current assets include cash, inventory, and accounts receivable. Examples of current liabilities include accounts payable, short-term debt, and the current portion of long-term debt.
Why Working Capital Is Included in NPV
The changes in net working capital associated with a project should be included in NPV calculations. Most projects require additional investments in working capital, such as increased inventories and accounts receivable, that are typically recovered at a later date. Working capital investments tie up resources that could otherwise be used to generate revenue for the business. The cash flow associated with these investments, like other project cash flows, must be captured in the NPV analysis.