Working capital refers to the difference between a company's current assets and current liabilities and is a measure of the operational liquidity required to fund day-to-day operations.
1. Impact of Working Capital on Cash Flows:
Changes in working capital can affect the cash flows used in the DCF analysis. An increase in working capital, such as higher accounts receivable or inventory levels, leads to a cash outflow, reducing the projected cash flows. Conversely, a decrease in working capital results in a cash inflow, increasing the projected cash flows.
2. Handling Changes in Working Capital:
To account for changes in working capital, the following steps can be taken in the DCF analysis:
a. Determine the Net Working Capital (NWC) Requirement:
Assess the historical relationship between revenue growth and working capital requirements. Calculate the average NWC as a percentage of revenue over a period of time, considering factors such as accounts receivable, inventory, and accounts payable.
b. Project Future NWC Needs:
Forecast the future revenue growth and estimate the corresponding changes in working capital based on the historical relationship determined in step a. Adjust the projected cash flows to reflect the changes in NWC requirements.
c. Include the NWC Investment in the Initial Cash Flow:
When calculating the initial cash flow for the DCF analysis, incorporate the net change in working capital as an investment. If working capital requirements increase, subtract the cash outflow from the initial cash flow. If working capital requirements decrease, add the cash inflow to the initial cash flow.
d. Terminal Value Considerations:
When determining the terminal value, ensure that the projected working capital requirements are consistent with the company's long-term growth assumptions. This can be achieved by assuming a constant percentage of revenue or by aligning working capital needs with industry benchmarks.
By incorporating changes in working capital in the DCF analysis, you account for the cash flow implications associated with the company's day-to-day operations. This approach provides a more accurate valuation by considering the capital needed to support ongoing business activities and maintaining a balanced financial projection.
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