A new project will increase inventory and accounts receivable by an average of $1 million each. Cash levels and other working capital accounts are expected to not change. What effect will the project have on working capital?
To determine the effect of the new project on working capital, we need to understand the components of working capital and how they relate to inventory and accounts receivable.
Working capital is defined as the difference between current assets and current liabilities. It represents the funds available to the company for day-to-day operations. It is calculated as:
Working Capital = Current Assets - Current Liabilities
In this case, the new project will increase both inventory and accounts receivable by an average of $1 million each. Since both inventory and accounts receivable are current assets, an increase in these accounts will lead to an increase in the numerator of the working capital equation.
However, the question states that cash levels and other working capital accounts are expected to not change. This means that current liabilities, which can include accounts payable and short-term loans, are expected to remain unchanged.
Since the current liabilities are not changing, the increase in the numerator (current assets) without a corresponding increase in the denominator (current liabilities) will result in an overall increase in working capital.
Therefore, the effect of the new project on working capital will be an increase of $1 million.
The project will have two main effects on working capital:
1. Increase in Inventory: Since the project is expected to increase inventory by an average of $1 million, there will be an increase in current assets. This increase in inventory will tie up additional cash in the form of raw materials, work in progress, and finished goods.
2. Increase in Accounts Receivable: The project is also anticipated to increase accounts receivable by an average of $1 million. This means that the company will have more outstanding customer invoices that have not been paid yet. The increase in accounts receivable will also tie up additional cash since the company has not received the full payment for these sales.
Overall, the project will increase working capital by $1 million, as there is an increase in both current assets (inventory and accounts receivable). It is important to note that other working capital accounts such as cash levels are expected to remain unchanged in this scenario.