Question 2 (a)
Replacement decision: relevant cash flows and NPV
15 marks
- Time to write
- About 30 minutes
Question
Question 2 (a) · 15 marksBrightline Industries is deciding whether to replace an existing machine which it bought three years ago for ₹24,00,000. The current machine has five years of useful life remaining, with no residual value at the end; it can, however, be sold now for ₹14,40,000. The maintenance costs of the existing machine are expected to rise by ₹1,20,000 annually from its sixth year.
An alternative machine, which is more efficient, is available for ₹36,00,000 and would have a resale value of ₹14,40,000 when its five-year life ends. This new machine is expected to increase annual revenue by ₹3,60,000 and to reduce operating costs by ₹2,40,000 each year. Brightline Industries follows the straight-line depreciation method, with a 50% tax rate and a 10% cost of capital. Compute the relevant cashflows and the Net Present Value (NPV). Should the company go ahead with replacing the 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
- Compute…Should…?Two asks in one question: answer both.
- Should the company…?A yes-or-no question: answer it in your first line, then explain why.
- replaceCash flows year by year in one table, then discount, then a one-line decision.
What the paper leaves open
The existing machine's "sixth year" is read as counted from its purchase three years ago, so the higher maintenance cost applies in the third, fourth and fifth years from now. "Rise by... annually" is read as the same extra amount in each of those years.
Write it in this order
- Read the data; note exactly what is asked 2 min
- 1 Initial outlay net of the sale of the existing machine 2 marks 4 min
- 2 Incremental depreciation 2 marks 4 min
- 3 Incremental cash flows after tax, including the maintenance saving and salvage 6 marks 11 min
- 4 Present values and NPV 3 marks 6 min
- 5 Decision 2 marks 1 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
Short on time? End with step 5's one-line decision, whatever happens: never leave the figures without it.
Try it first. About 30 minutes for 15 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.
Assumptions. The existing machine had an 8-year life (3 years used, 5 left) with no residual value, so its straight-line depreciation is ₹24,00,000 ÷ 8 = ₹3,00,000 a year, and its book value now is ₹15,00,000. The question says nothing about tax on its sale, so none is taken. Present value factors at 10% are from the table (3 decimals).
| ₹ | |
|---|---|
| Cost of the new machine | 36,00,000 |
| Less: sale value of the existing machine | 14,40,000 |
| Net initial outlay | 21,60,000 |
2. Incremental depreciation. New machine: (36,00,000 − 14,40,000) ÷ 5 = ₹4,32,000. Existing machine: ₹3,00,000. Incremental depreciation = ₹1,32,000 a year.
3. Incremental annual cash flows (benefits of the new machine: extra revenue ₹3,60,000 + saving in operating costs ₹2,40,000, plus, in years 3–5, the ₹1,20,000 extra maintenance the existing machine would have needed)
| Year | Incremental benefit before depreciation and tax | Less: incremental depreciation | Profit before tax | Tax @ 50% | Profit after tax | Add: depreciation | CFAT | Salvage of new machine | Net cash flow | PV factor @ 10% | Present value |
|---|---|---|---|---|---|---|---|---|---|---|---|
| 1 | 6,00,000 | 1,32,000 | 4,68,000 | 2,34,000 | 2,34,000 | 1,32,000 | 3,66,000 | — | 3,66,000 | 0.909 | 3,32,694 |
| 2 | 6,00,000 | 1,32,000 | 4,68,000 | 2,34,000 | 2,34,000 | 1,32,000 | 3,66,000 | — | 3,66,000 | 0.826 | 3,02,316 |
| 3 | 7,20,000 | 1,32,000 | 5,88,000 | 2,94,000 | 2,94,000 | 1,32,000 | 4,26,000 | — | 4,26,000 | 0.751 | 3,19,926 |
| 4 | 7,20,000 | 1,32,000 | 5,88,000 | 2,94,000 | 2,94,000 | 1,32,000 | 4,26,000 | — | 4,26,000 | 0.683 | 2,90,958 |
| 5 | 7,20,000 | 1,32,000 | 5,88,000 | 2,94,000 | 2,94,000 | 1,32,000 | 4,26,000 | 14,40,000 | 18,66,000 | 0.621 | 11,58,786 |
| Total PV | 24,04,680 |
The existing machine has no residual value at the end of year 5, so the whole resale value of the new machine, ₹14,40,000, is an incremental terminal inflow.
| ₹ | |
|---|---|
| Total present value of incremental inflows | 24,04,680 |
| Less: net initial outlay | 21,60,000 |
| NPV | 2,44,680 |
Decision. The NPV of replacing is positive (₹2,44,680), so Brightline Industries should replace the existing machine.
Where the 15 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Initial outlay net of the sale of the existing machine | 2 |
| 2 | Incremental depreciation | 2 |
| 3 | Incremental cash flows after tax, including the maintenance saving and salvage | 6 |
| 4 | Present values and NPV | 3 |
| 5 | Decision | 2 |
| Total | 15 |
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