Question 1 (b)
Computerisation project: NPV with and without a book salvage value
11 marks
- Time to write
- About 22 minutes
From an older CBCS paper
Question
Question 1 (b) · 11 marksA company is considering computerizing its inventory and billing procedures, at a cost of ₹ 2,40,000. The Installation charges are ₹ 60,000. On a straight-line basis, these outlays will be depreciated to a zero book value, which will also be the salvage value at the end of the 5 years of its life. The new system needs two Computer specialists, on annual salaries of ₹ 48,000 per person. Annual maintenance expenses of ₹ 14,400 are also estimated to be incurred. Production delays will be reduced by the new system, saving ₹ 24,000 annually. It will also help avoid a stock out cost of ₹ 30,000 per year. Timely billing will raise inflow by ₹ 9,600 per year. Six clerical employees, on annual salaries of ₹ 24,000 each, will also become redundant. The tax rate of the company is 30%, and its required rate of return 12%. Evaluate the project.
What will your decision be if, for the purpose of calculating depreciation, the salvage value is taken as ₹ 36,000, even though in terms of resale value the machine will be worthless after 5 years ? 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
- EvaluateBoth sides: the strengths, the limits, then your own view.
- computerizingFormula first, then the working, then the answer with its unit (₹, %, units).
- your decisionEnd with a one-line decision that follows from your figures.
What the paper leaves open
- The six clerical salaries saved are a cash saving.
- In the second case the system is depreciated to ₹ 36,000 but sells for nothing; the book value left at the end of year 5 is written off as a loss with its tax effect, and this is stated.
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Net annual saving 3 marks 6 min
- 2 Case 1: depreciation, cash inflow and NPV 4 marks 7 min
- 3 Case 2: depreciation, year-5 loss and NPV 3 marks 6 min
- 4 Decision 1 mark 1 min
- Check: arithmetic, units (₹, %), final answer underlined 1 min
Short on time? End with step 4'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.
Annual cash saving before depreciation and tax (₹)
| Particulars | ₹ |
|---|---|
| Production delays avoided | 24,000 |
| Stock-out cost avoided | 30,000 |
| Faster billing: extra inflow | 9,600 |
| Salaries of six clerical employees (6 × 24,000) | 1,44,000 |
| Gross savings | 2,07,600 |
| Salaries of two computer specialists (2 × 48,000) | 96,000 |
| Annual maintenance | 14,400 |
| Extra costs | 1,10,400 |
| Net annual saving (2,07,600 − 1,10,400) | 97,200 |
Outlay = 2,40,000 + 60,000 = ₹3,00,000. Depreciation is non-cash; its tax saving is a cash inflow.
Case 1: depreciation to a nil book value. Depreciation = 3,00,000 ÷ 5 = ₹60,000; EBT = 37,200; tax @ 30% = 11,160.
| Particulars | ₹ |
|---|---|
| Earnings after tax | 26,040 |
| Add: depreciation | 60,000 |
| Cash inflow after tax (years 1–5) | 86,040 |
PV = 86,040 × 3.605 (annuity factor, 5 years at 12%) = ₹3,10,174.20; NPV = ₹10,174.20: accept.
Case 2: depreciation to a book salvage of ₹36,000. Depreciation = (3,00,000 − 36,000) ÷ 5 = ₹52,800; EBT = 44,400; tax = 13,320.
| Particulars | ₹ |
|---|---|
| Earnings after tax | 31,080 |
| Add: depreciation | 52,800 |
| Cash inflow after tax (years 1–5) | 83,880 |
The system is worthless after 5 years, so its ₹36,000 book value is written off as a loss in year 5, saving tax of ₹10,800 (paper note 2): year-5 inflow = 83,880 + 10,800 = ₹94,680. PV = 83,880 × 3.605 + 10,800 × 0.567 = 3,02,387.40 + 6,123.60 = ₹3,08,511; NPV = ₹8,511: accept.
Evaluation. The project should be accepted: its NPV is positive either way, and a project is accepted when its NPV is positive. The book salvage of ₹36,000 only delays part of the depreciation tax saving to year 5, which lowers the NPV by ₹1,663.20 but does not change the decision.
Where the 11 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Net annual saving | 3 |
| 2 | Case 1: depreciation, cash inflow and NPV | 4 |
| 3 | Case 2: depreciation, year-5 loss and NPV | 3 |
| 4 | Decision | 1 |
| Total | 11 |
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