Question

your company is interested in investing capital in buying machinery in about 13 years when the LCC states machinery might fail. Your manager says right now you only have$150,000 in capital to invest. Your company needs to have on hand $500,000 to buy the machinery and another $150,000 in working capital to make sure you have a safety net. What would you tell your manager about this situation?

Answer 1

Let us try to analyse the situation. The machine is due for purchase in 13 years and the firm has some idle capital of $150,000.

Total capital required at the end of 13 years = 500,000 + 150,000 = $650,000

If I invest my money right now at r% p.a for 13 years, I should have enough money to buy the machinery.

Hence, 150,000 * (1+r)¹³ = 650,000

r = 11.94%

The firm needs to invest this money so that it at least earns at the rate of 11.94%. This has to be compared with various options:

i. Investing in financial assets that can generate such a return. However, this seems to be unlikely

ii. Investing in operating assets or projects of not more than 13 years of useful life and comparing the returns (Internal rate of return) with the cost of capital for the firm.

However, let the boss be advised that it is wise to invest the money rather than sitting on a pile of idle cash.