Question 2 OR (a)
Replacement: incremental cash flows and break-even rate
15 marks
- Time to write
- About 30 minutes
Question
Question 2 OR (a) · 15 marksKalinga Company is considering the replacement of its existing machine with a new model costing ₹1,92,000. The proposed machine, with a useful life of 5 years, is expected to generate annual cash revenues of ₹3,00,000 while incurring cash expenses of ₹1,56,000 per year; its anticipated salvage value is zero. The existing machine, whose current book value is ₹48,000, could be sold now for ₹24,000. It can operate for the next 5 years, over which it is expected to produce annual cash revenues of ₹2,40,000 and to incur annual cash expenses of ₹1,68,000, with zero salvage value at the end of its life. The corporate tax rate is 40%, and depreciation is calculated at a rate of 25% on the basis of written-down value (WDV). Any taxes on capital gains or losses are to be ignored in this analysis.
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
- replacementCash flows year by year in one table, then discount, then a one-line decision.
What the paper leaves open
The paper states no requirement and gives no cost of capital. It is read as asking for the incremental cash flows of the replacement over the five years and whether the replacement is worth making on those cash flows.
Write it in this order
- Read the data; note exactly what is asked 2 min
- 1 Net initial outlay 2 marks 4 min
- 2 Incremental cash operating profit 2 marks 3 min
- 3 WDV depreciation of each machine 3 marks 5 min
- 4 Incremental cash flows after tax 5 marks 9 min
- 5 Decision and break-even rate 3 marks 5 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.
Reading (paper note). No requirement or cost of capital is printed. The answer gives the incremental cash flows of the replacement over five years, judges it on those flows, and states the rate of return at which the replacement stops being worthwhile. Each machine is depreciated on its own at 25% WDV; tax on the sale of the old machine is ignored, as the question says.
1. Net initial outlay: cost of new machine ₹1,92,000 − sale of existing machine ₹24,000 = ₹1,68,000.
2. Incremental cash operating profit (each year): new (3,00,000 − 1,56,000 = 1,44,000) − existing (2,40,000 − 1,68,000 = 72,000) = ₹72,000.
| Year | New machine (on ₹1,92,000) | Existing machine (on ₹48,000) | Incremental depreciation |
|---|---|---|---|
| 1 | 48,000.00 | 12,000.00 | 36,000.00 |
| 2 | 36,000.00 | 9,000.00 | 27,000.00 |
| 3 | 27,000.00 | 6,750.00 | 20,250.00 |
| 4 | 20,250.00 | 5,062.50 | 15,187.50 |
| 5 | 15,187.50 | 3,796.88 | 11,390.62 |
4. Incremental cash flows after tax
| Year | Incremental cash profit | Less: incremental depreciation | Profit before tax | Tax @ 40% | Profit after tax | Add: depreciation | Incremental CFAT |
|---|---|---|---|---|---|---|---|
| 1 | 72,000.00 | 36,000.00 | 36,000.00 | 14,400.00 | 21,600.00 | 36,000.00 | 57,600.00 |
| 2 | 72,000.00 | 27,000.00 | 45,000.00 | 18,000.00 | 27,000.00 | 27,000.00 | 54,000.00 |
| 3 | 72,000.00 | 20,250.00 | 51,750.00 | 20,700.00 | 31,050.00 | 20,250.00 | 51,300.00 |
| 4 | 72,000.00 | 15,187.50 | 56,812.50 | 22,725.00 | 34,087.50 | 15,187.50 | 49,275.00 |
| 5 | 72,000.00 | 11,390.62 | 60,609.38 | 24,243.75 | 36,365.63 | 11,390.62 | 47,756.25 |
| Total | 2,59,931.25 |
Both machines have nil salvage value at the end of five years, so there is no terminal inflow.
5. Is the replacement worthwhile? Over five years the replacement returns ₹2,59,931.25 of incremental cash flow for an outlay of ₹1,68,000, recovering the outlay in about 3.1 years. On these cash flows it is worthwhile.
6. Break-even rate. The rate at which the present value of the incremental cash flows just equals the outlay (the IRR of the replacement) is 17.21%. The replacement is worthwhile so long as the firm's cost of capital is below 17.21%; at a cost of capital above 17.21% its NPV becomes negative and the existing machine should be kept.
Where the 15 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Net initial outlay | 2 |
| 2 | Incremental cash operating profit | 2 |
| 3 | WDV depreciation of each machine | 3 |
| 4 | Incremental cash flows after tax | 5 |
| 5 | Decision and break-even rate | 3 |
| Total | 15 |
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