Question 1 (b)
Replacement decision: incremental cash flows and NPV at 15%
11 marks
- Time to write
- About 22 minutes
From an older CBCS paper
Question
Question 1 (b) · 11 marksA company plans to replace a machine that is needed for 4 more years. The machine's book value is Rs 1,92,000, and will be fully depreciated at the end of 2 years. The machine will generate revenue of Rs 6,24,000 per year for 4 years, and incur expenses of Rs. 4,56,000 per year. Its salvage value now is Rs 1,44,000, which will fall to zero after 4 years. It can be replaced with a machine costing Rs 5,76,000. The new machine is expected to generate revenue of Rs 11,04,000 per year, with annual expenses of Rs 6,96,000. If the new machine is bought, Additional working capital of Rs 2,40,000 will be needed. Depreciation will be charged on the new machine at Rs 96,000 per year, so that its book value equals its expected salvage value, Rs 1,92,000, at the end of the fourth year. The company's tax rate is 30%, and its cost of capital is 15%. Advise the company on the replacement.
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
- replaceCash flows year by year in one table, then discount, then a one-line decision.
What the paper leaves open
- The old machine is fully depreciated in 2 years, so its depreciation stops after year 2.
- No tax on the sale of the old machine, or on the new machine's terminal sale at book value, unless stated (C7).
- The working capital is recovered at the end of year 4.
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Initial cash outflow 2 marks 4 min
- 2 Incremental EBDT and incremental depreciation 3 marks 5 min
- 3 Cash inflows after tax 3 marks 5 min
- 4 Terminal inflows and present values 2 marks 4 min
- 5 NPV and advice 1 mark 2 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.
Initial cash outflow. For a replacement: cost of the new asset, plus the increase in working capital, less the net proceeds from the old asset, adjusted for tax on its sale; no tax on the sale is stated (paper note 2).
| Particulars | ₹ |
|---|---|
| Cost of the new machine | 5,76,000 |
| Additional working capital | 2,40,000 |
| Total | 8,16,000 |
| Less: sale of the old machine | 1,44,000 |
| Initial cash outflow | 6,72,000 |
Incremental operating profit before depreciation and tax = (11,04,000 − 6,96,000) − (6,24,000 − 4,56,000) = 4,08,000 − 1,68,000 = ₹2,40,000 a year.
Incremental depreciation. New machine ₹96,000 a year. The old machine's ₹1,92,000 book value would have been written off over the next 2 years at ₹96,000 a year (paper note 1), and that depreciation is lost on replacement. Only the incremental depreciation affects the tax, and its tax saving is a cash inflow.
Incremental cash flows after tax (₹)
| Year | Incremental EBDT | Incremental depreciation (96,000 − old) | EBT | Tax @ 30% | EAT | Add: incremental depreciation | Cash inflow after tax |
|---|---|---|---|---|---|---|---|
| 1 | 2,40,000 | 0 | 2,40,000 | 72,000 | 1,68,000 | 0 | 1,68,000 |
| 2 | 2,40,000 | 0 | 2,40,000 | 72,000 | 1,68,000 | 0 | 1,68,000 |
| 3 | 2,40,000 | 96,000 | 1,44,000 | 43,200 | 1,00,800 | 96,000 | 1,96,800 |
| 4 | 2,40,000 | 96,000 | 1,44,000 | 43,200 | 1,00,800 | 96,000 | 1,96,800 |
| Year | Cash inflow | PV factor @ 15% | Present value |
|---|---|---|---|
| 1 | 1,68,000 | 0.870 | 1,46,160 |
| 2 | 1,68,000 | 0.756 | 1,27,008 |
| 3 | 1,96,800 | 0.658 | 1,29,494.40 |
| 4 (1,96,800 + salvage 1,92,000 + working capital 2,40,000) | 6,28,800 | 0.572 | 3,59,673.60 |
| Total present value | 7,62,336 | ||
| Less: initial cash outflow | 6,72,000 | ||
| NPV | 90,336 |
Advice. The NPV is positive, ₹90,336; a project is accepted when its NPV is positive. The company should replace the machine. The new machine sells at its book value, so there is no gain or loss on its sale; the working capital is recovered at the end of year 4 (paper note 3).
Where the 11 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Initial cash outflow | 2 |
| 2 | Incremental EBDT and incremental depreciation | 3 |
| 3 | Cash inflows after tax | 3 |
| 4 | Terminal inflows and present values | 2 |
| 5 | NPV and advice | 1 |
| Total | 11 |
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