Question 1 (b)
Replacement on labour saving: NPV
11 marks
- Time to write
- About 22 minutes
From an older CBCS paper
Question
Question 1 (b) · 11 marksSTU Ltd.'s income statement for the current year is as below:
| Particulars | Amount (₹) | Amount (₹) |
|---|---|---|
| Sales | 8,40,000 | |
| Less: Costs | ||
| Materials | 2,40,000 | |
| Labour | 3,00,000 | |
| Other Operating costs | 96,000 | |
| Depreciation | 84,000 | |
| Total | 7,20,000 | |
| Earnings Before Interest and Taxes (EBIT) | 1,20,000 | |
| Less: Taxes @ 40% | 48,000 | |
| Earnings after Tax (EAT) | 72,000 |
The plant manager proposes replacing an existing machine with another one costing ₹ 2,88,000. The new machine's life will be 8 years, with no salvage value. The new machine is estimated to cut the labour cost by ₹ 60,000 per year. The old machine will realize ₹ 48,000. The income statement has no depreciation on the old machine (the one to be replaced), since it was fully depreciated for tax purposes last year, though, if not replaced, it would go on functioning for a few more years. The replacement is not expected to change the firm's other expenses and revenues. The company requires a return of 12% after tax. The tax rate applicable to the company's income is 30%. Assuming that the company follows the straight line method of depreciation, which is allowed for tax purposes, suggest whether it should buy the new machine. 11
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
- Assuming that the company follows the…The paper fixes this: use it as given, and say so in your answer.
- replacingCash flows year by year in one table, then discount, then a one-line decision.
What the paper leaves open
The income statement shows tax at 40% while the narrative gives 30% as the rate applicable to the company's income; the answer uses 30%, the rate stated for the decision, and shows the result at 40% as the other reading. The old machine's sale proceeds are taken without tax (fully depreciated; C7).
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Net cash outlay and depreciation 3 marks 6 min
- 2 Annual cash inflow after tax 4 marks 7 min
- 3 Present value and NPV 3 marks 5 min
- 4 Suggestion 1 mark 2 min
- Check: arithmetic, units (₹, %), final answer underlined 1 min
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 the changes caused by the replacement count. The old machine is fully depreciated, so no depreciation is lost; it is sold for ₹48,000, untaxed (paper note). Tax is taken at 30%, the rate stated for the company's income (paper note); the income statement's 40% is the other reading.
- Net cash outlay = 2,88,000 − 48,000 = ₹2,40,000.
- Depreciation on the new machine (straight line, 8 years, nil salvage) = 2,88,000 ÷ 8 = ₹36,000 a year; depreciation is a non-cash item whose tax saving is a cash inflow.
Annual incremental cash inflow (years 1 to 8)
| Particulars | ₹ |
|---|---|
| Saving in labour cost | 60,000 |
| Less: depreciation | 36,000 |
| Increase in profit before tax | 24,000 |
| Less: tax @ 30% | 7,200 |
| Increase in profit after tax | 16,800 |
| Add: depreciation | 36,000 |
| Annual cash inflow after tax | 52,800 |
NPV at 12%. PV of inflows = 52,800 × 4.968 (annuity factor, 8 years at 12%) = ₹2,62,310.40. NPV = 2,62,310.40 − 2,40,000 = ₹22,310.40.
Suggestion. A project with a positive NPV is accepted, so the company should buy the new machine.
The other reading. At the 40% rate shown in the income statement, the annual cash inflow is 60,000 × 0.60 + 0.40 × 36,000 = ₹50,400 and the NPV is ₹10,387.20: still positive, so the decision is the same.
Where the 11 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Net cash outlay and depreciation | 3 |
| 2 | Annual cash inflow after tax | 4 |
| 3 | Present value and NPV | 3 |
| 4 | Suggestion | 1 |
| Total | 11 |
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