Do You Include Working Capital in Net Present Value (NPV)?
Analyzing an investment before jumping in is a laborious, yet crucial, step. Figuring out how much a company is worth is essential to figuring out if the company’s stock is over or under priced.
Net present value (NPV) is one of the main fundamental valuation methods, often called Discounted Cash Flow (DCF) analysis by investors.
Key Takeaways
- Net present value is the difference between the present value of the incoming cash flows and the present value of the outgoing cash flows.
- Working capital is the difference between a company’s current assets and its current liabilities.
- Working capital is included when calculating net present value (NPV).
How to Calculate Net Present Value (NPV)
Understanding If You Include Working Capital in Net Present Value
Net Present Value
Net present value is the discounted value of future cash flows of a project or investment. A positive NPV indicates a profitable investment, while a negative NPV indicates a loss-producing investment. Changes in working capital are an integral component in calculating net cash flow.
Net present value is frequently used for budgeting, accounting, and investment analysis purposes. It is based on the assumption that money today is worth more than money in the future. This is due to assumed inflation and opportunity cost from not having the money in the meantime.
To account for the time value of money, analysts often apply a discount rate when calculating the value of money in the future. Using NPV to value investments has its advantages, but there are drawbacks as well. NPV calculation relies heavily on assumptions and estimates. Several factors could affect the future value of an investment that is not predicted by the model. The longer the time frame of the investment, the more risk there is of this.
Working Capital
Working capital is the difference between a company’s current assets and its current liabilities. Current assets can include things like cash, accounts receivable, and inventories. Current liabilities can include things like accounts payable or money owed. Working capital is calculated by simply subtracting current liabilities from current assets.
If working capital increases year over year, the company has tied up more cash in working capital. This will be reflected as a reduction in cash in the NPV calculation. If working capital decreases, the company has released cash and so this is reflected as an increase in cash in the NPV calculation.
Accordingly, cash flow decreases as accounts receivables increase or accounts payables decrease. Therefore, as working capital changes from period to period, it has an effect on cash flow, which in turn affects NPV.
Working capital is a measure of both a company’s short-term financial health and its operational efficiency.