Discussion Issues and Derivations
- Cash versus Non-Cash Working Capital
Working capital is sometimes used to refer only to current assets, while net working capital is defined to be the difference between current assets and current liabilities. Non-cash working capital looks at the difference between non-cash current assets and current liabilities.
In investment analysis, increases in working capital are viewed as cash outflows, because cash tied up in working capital cannot be used elsewhere in the business and does not earn returns. It is the "does not earn returns" component of this definition that would lead us to look at non-cash working capital. Firms with significant cash balances today, especially in the US, earn market returns on their cash (by investing in at least T.Bills0). Thus, the cash is productive and changes in the cash should not affect our cash flows.
To the degree that cash cannot be invested to earn market returns, and is needed for day-to-day operations, it is appropriate to look at changes in net working capital, with cash included.
- The Working Capital Effect on Cash Flows and Value
An increase in working capital implies that more cash is invested in working capital and thus reduces cash flows. Firms with significant working capital requirements will find that their working capital grows as they do, and this working capital growth will reduce their cash flows.
Given this relationship between working capital and cash flows, firms which are more efficient about managing working capital, will have a higher value than an otherwise similar firm with greater working capital requirements.
Firms should also think about the trade off between greater revenues and working capital requirements. As an example, granting credit may increase sales and profits, but it also increases working capital needs. The net effect can be positive or negative for value.
- The Discount Rate in Working Capital Decisions
Many academics and most practitioners seem unified in the use of the cost of debt as the discount rate in working capital decisions. Let me try to present you my rationale for the use of the cost of capital and why I believe that the cost of debt is not the right discount rate.
I come into this process as someone who is interested in the overall value of a firm. When valuing a firm, I dicount free cash flows to the firm at the cost of capital, where free cash flow to the firm is conventionally defined as:
FCFF = EBIT (1- tax rate) + Depreciation - Capital Expenditures - Changes in Working Capital
Any action that increases working capital (such as granting longer credit terms) reduces my cash flow, and my value is reduced by the present value of these working capital changes, discounted back at the cost of capital. Thus, it seems to me fundamentally consistent to look at working capital changes through this prism and use the cost of capital as the discount rate.
When I make this argument, I hear two counter arguments. The first is that the firm borrows the money to finance the loosening of credit. This argument does not hold up, if this is a long term change in corporate strategy, rather than granting longer credit terms to one customer. If it is, in fact, a change in corporate strategy, the firm has to finance this permanent shift in working capital not with debt alone, but with the mix of debt and equity that the firm has chosen as its target capital structure. Otherwise, it will end up as over levered. The second is that working capital investments are somehow less risky than traditional capital expenditures - thus, the argument goes, the cost of capital is used for traditional projects but the cost of debt for working capital investments. This does not make any sense to me, either. Working capital investments are not stand-alone projects, but are investments that derive from other capital investments. Thus, the decision to grant credit to a customer who buys a product manufactured in a factory built by a firm cannot be separated from the primary investment in the factory. To argue that the investment in the factory is risky (and thus should have its cash flows discounted back at the cost of capital), but that the credit demands that flow from the factory are safer and should be discounted at the cost of debt is to me inconsistent. In fact, many of the CFOs that I talked to who used the cost of debt in discounting working capital decisions when made separately, used the cost of capital to discount cash flows in new project analysis, and these cash flows were after working capital changes.
While I do not disagree with the fact that less risky cash flows should have lower discount rates, working capital does not fit the bill of less risky. I think that for a truly one-time decision on credit to a customer, it might be appropriate to use the cost of debt (using the default risk of the customer, in fact, in coming up with the cost of debt). For decisions that affect the broad cross section of customers over time, I still think that it is appropriate to use the cost of capital.