Mercy’s Limited: Capital Budgeting, Term Paper Example

Our company, Macy’s limited, deals with the production of iron sheets and is considering acquiring a new machine to replace the existing one. The main intention in this undertaking is to enhance the efficiency in the production to meet the rising demand of its product. This is expected to minimize operating costs and to boost the profitability of the firm.

However, the company is facing a number of challenges in an effort to access funding for its capital investment. These challenges include:

1. Financing costs- the bank interest rates are more likely to rise or yield a curve steepening. This can be attributed to the fact that the effects of global economic depression continue to augment this interest as the banks attempts to shift the strain to their borrowers.
2. Substantial capital reinvestment needs- Any new machine requires some modifications which might be immediate or otherwise. This implies that some additional investment might be needed to get the machine fully operational after its acquisition.
3. Lengthy and strict procedures for soliciting the required funding- this might take a lengthy period than anticipated and in case one method fails, then a whole procedure will have be started all over again.
4. Risk involved- the project might be termed as a risky one by the financing institutions and this might augment the interest rate payable on the funding rendered to us, or in the worst case scenario, they might refuse to fund the project altogether (Arthur and Sheffrin 58).

Estimates of the initial investment and the annual incremental after tax cash flows

The machine to be acquired will cost $50,000 with a modification cost of $10,000. The project will necessitate an additional working capital of $2,000. The machine to be replaced has a book value of $20,000 and a remaining lifespan of 3 years. The applicable tax rate is 30%.

Net Initial Investment

Machine purchase price                                                           $50,000

Modification cost                                                                       $10,000

$60,000

Additional investment in working capital                              $2,000

Total initial investment                                                            $62,000

Incremental Operating Cash Flows

Savings in pre-tax operating costs                                          $20,000

Less tax                                                                                         ($6,000)

Incremental after tax saving                                                    $14,000

Add depreciation tax shield benefit (D.T.S)

{$60,000 – $20,000} * 30% =                                                 $4,000

3

Incremental cash flow                                                               $18,000 p.a. for 3 years

Conclusion

Mercy’s investment in the new machine is viable as it has positive incremental cash flows.

Works Cited

Arthur, Sullivan and Sheffrin, Steven M. Economics: Principles in action. Upper Saddle River: New Jersey, 2003.

“Capital budgeting.” StudyFinance.com. 29 Nov. 1999. 02 Feb. 2000 <http://www.studyfinance.com/lessons/capbudget/index.mv>

“Profitability Index – Investment Ranking tool. 22 June 2001. 01 Aug. 2001 <http://www.financescholar.com/profitability-index.html>