Additional Working Capital Required

If you are doing MBA or MSc in Finance from UK, you will see additional working capital required term in its given finance books (when you study capital budgeting topic). You can find it in following problem.




In above question, you are seeing that a person has to choose one of the investment out of two alternatives of investment. For this, he has to calculate payback period. For calculating the payback period, he has to understand "additional working capital required". Only after understanding, he can calculate payback correctly. 

Meaning of Additional working capital Required 

Additional working capital required means need of more working capital for producing goods or paying day to day expenses and paying current liabilities or getting extra current assets. Its main source is our earned profit, cash in hand and bank overdraft and short term loan. 

So, one side it will include cash inflow and other side it will include cash outflow or investment. But remember it will not include for calculating depreciation. 

Now, understand this. 

Why does it not include in investment for calculating depreciation? 

Answer is simple, we need it after investing money (it may be estimated or actual, forget it) in investment. So, we calculate depreciation by initial investment - scrape / useful life when we follow the straight line method. 

Why does it include both in investment or cash outflow and cash inflow?

Additional working capital required is past sense. It means, first we get it from cash profit or other sources and then we included it in fixed asset or investment. 

Why does it include for finding Annual Cash inflow?

Lack of information, it is very difficult for any finance expert what is the source of additional working capital, as our thinking, it is taken from cash profit.  So, we profit will be before depreciation. So, we will include it only for calculating annual cash inflow, when there are lots of years net profit will be given. 




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