Question 1 OR (b)
New product: incremental cash flows and NPV at 15%
11 marks
- Time to write
- About 22 minutes
From an older CBCS paper
Question
Question 1 OR (b) · 11 marksA company is considering a proposal to produce a new product. It expects to sell 1,00,000 units of it a year, at a selling price of Rs 5 per unit, with a Variable cost of Rs 2 per unit. Whatever the level of production, the company will incur a cash cost of Rs. 60,000 a year if the project is undertaken. The machine to make the product will cost Rs. 6,00,000, and can be sold for Rs 72,000 after the end of its life of 5 years. The Additional working capital needed will be Rs 60,000. The Overhead cost to be allocated to the new product will be Rs. 28,800 a year. The tax rate is 30%, and the company's cost of capital is 15%. Depreciation is charged by the company at 25% of the written down value. Should it buy the new machine?
Reworded from the university paper: names and figures differ, the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- Should it buy…?A yes-or-no question: answer it in your first line, then explain why.
- Should itEnd with a one-line decision that follows from your figures.
What the paper leaves open
- The allocated overhead is not an incremental cost and is left out of the cash flows.
- The machine sells at the end of year 5 for less than its written down value; the answer treats the shortfall as a loss with its tax effect, and states this.
- Working capital is recovered at the end of year 5.
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Relevant cash profit (allocated overhead excluded) and initial outflow 2 marks 4 min
- 2 WDV depreciation and cash inflows after tax 4 marks 7 min
- 3 Terminal inflows: sale, tax on the loss, working capital 2 marks 4 min
- 4 Present values and NPV 2 marks 4 min
- 5 Advice 1 mark 1 min
- Check: arithmetic, units (₹, %), final answer underlined 1 min
Short on time? End with step 5's one-line decision, whatever happens: never leave the figures without it.
Try it first. About 22 minutes for 11 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Relevant cash flows. Only incremental cash flows count. The allocated overhead of ₹28,800 is a share of costs the company incurs anyway, so it is left out (paper note 1).
Annual cash profit before depreciation and tax = 1,00,000 × (5 − 2) − 60,000 = ₹2,40,000. Initial outflow = machine 6,00,000 + working capital 60,000 = ₹6,60,000.
Depreciation and cash inflows after tax (₹) (WDV at 25%; depreciation is non-cash and its tax saving is a cash inflow)
| Year | Opening WDV | Depreciation @ 25% | EBT (2,40,000 − dep.) | Tax @ 30% | EAT | Add: depreciation | Cash inflow after tax |
|---|---|---|---|---|---|---|---|
| 1 | 6,00,000 | 1,50,000 | 90,000 | 27,000 | 63,000 | 1,50,000 | 2,13,000 |
| 2 | 4,50,000 | 1,12,500 | 1,27,500 | 38,250 | 89,250 | 1,12,500 | 2,01,750 |
| 3 | 3,37,500 | 84,375 | 1,55,625 | 46,687.50 | 1,08,937.50 | 84,375 | 1,93,312.50 |
| 4 | 2,53,125 | 63,281.25 | 1,76,718.75 | 53,015.62 | 1,23,703.13 | 63,281.25 | 1,86,984.38 |
| 5 | 1,89,843.75 | 47,460.94 | 1,92,539.06 | 57,761.72 | 1,34,777.34 | 47,460.94 | 1,82,238.28 |
Terminal inflows, end of year 5. WDV after five years = ₹1,42,382.81; sale proceeds ₹72,000; loss = ₹70,382.81, which saves tax of 30% = ₹21,114.84 (paper note 2). Working capital ₹60,000 is recovered (paper note 3).
| Year | Cash inflow | PV factor @ 15% | Present value |
|---|---|---|---|
| 1 | 2,13,000 | 0.870 | 1,85,310 |
| 2 | 2,01,750 | 0.756 | 1,52,523 |
| 3 | 1,93,312.50 | 0.658 | 1,27,199.62 |
| 4 | 1,86,984.38 | 0.572 | 1,06,955.07 |
| 5 (1,82,238.28 + sale 72,000 + tax saving on loss 21,114.84 + working capital 60,000) | 3,35,353.12 | 0.497 | 1,66,670.50 |
| Total present value | 7,38,658.19 | ||
| Less: initial outflow | 6,60,000 | ||
| NPV | 78,658.19 |
Advice. A project is accepted if its NPV is positive. The NPV is ₹78,658.19, so the company should buy the machine and produce the new product.
Where the 11 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Relevant cash profit (allocated overhead excluded) and initial outflow | 2 |
| 2 | WDV depreciation and cash inflows after tax | 4 |
| 3 | Terminal inflows: sale, tax on the loss, working capital | 2 |
| 4 | Present values and NPV | 2 |
| 5 | Advice | 1 |
| Total | 11 |
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