Question 2 OR
Replacement decision: higher output machine
15 marks
- Time to write
- About 30 minutes
From an older CBCS paper
Question
Question 2 OR · 15 marksLMN Ltd. has a machine that has been in operation for 3 years, and still has a useful life of 8 years remaining, with no salvage value, and its current market value is Rs. 2,40,000. The company is considering a proposal to buy a new model of machine in place of the existing one. The relevant details are below:
| Existing Machine | New Machine | |
|---|---|---|
| Cost of machine | Rs. 3,96,000 | Rs. 12,00,000 |
| Life (estimated) | 11 years | 8 years |
| Salvage value | nil | Rs. 48,000 |
| Annual output | 36000 units | 90000 units |
| Selling price per unit | Rs.15 | Rs.15 |
| Operating hours (annual) | 3000 | 3000 |
| Per unit material cost | Rs. 4 | Rs. 4 |
| Per hour labour cost | Rs. 40 | Rs.70 |
| Indirect cash cost per annum | Rs.60000 | Rs.78000 |
Depreciation is charged by the straight-line method, and the corporate tax rate is 30%. LMN Ltd. makes no investment that yields less than 12%. Advise LMN Ltd. on whether or not to replace the existing machine. Ignore capital gain tax. 15
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
- Ignore capital gain taxThe paper fixes this: use it as given, and say so in your answer.
- replaceCash flows year by year in one table, then discount, then a one-line decision.
What the paper leaves open
- The existing machine is depreciated straight line on its cost over its 11-year life; capital gains tax is ignored as instructed, and the old machine's sale value is used without tax (C7).
- Labour cost is per operating hour.
Write it in this order
- Read the data; note exactly what is asked 2 min
- 1 Cash profit of each machine and the increment 4 marks 7 min
- 2 Depreciation and incremental depreciation 2 marks 4 min
- 3 Annual cash inflow after tax 3 marks 5 min
- 4 Net cash outlay 2 marks 3 min
- 5 NPV and advice 4 marks 7 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.
Annual operating cash profit (before depreciation and tax) (₹). Labour cost is per operating hour (paper note).
| Particulars | Existing machine | New machine |
|---|---|---|
| Output (units) | 36,000 | 90,000 |
| Sales @ ₹15 | 5,40,000 | 13,50,000 |
| Less: material @ ₹4 | 1,44,000 | 3,60,000 |
| Less: labour (3,000 hours × ₹40 / ₹70) | 1,20,000 | 2,10,000 |
| Less: indirect cash cost | 60,000 | 78,000 |
| Cash profit before depreciation and tax | 2,16,000 | 7,02,000 |
Incremental cash profit = 7,02,000 − 2,16,000 = ₹4,86,000 a year.
Depreciation. Existing: 3,96,000 ÷ 11 = 36,000 a year (book value now 2,88,000), lost on replacement. New: (12,00,000 − 48,000) ÷ 8 = 1,44,000. Incremental = ₹1,08,000; its tax saving is a cash inflow.
Annual incremental cash inflow (years 1–8): EBT = 4,86,000 − 1,08,000 = 3,78,000; tax @ 30% = 1,13,400.
| Particulars | ₹ |
|---|---|
| Increase in profit after tax | 2,64,600 |
| Add: incremental depreciation | 1,08,000 |
| Annual cash inflow after tax | 3,72,600 |
Net cash outlay. For a replacement, the new cost less the net proceeds of the old asset: 12,00,000 − 2,40,000 = ₹9,60,000 (capital gains tax ignored, as instructed; paper note).
NPV at 12%. PV of inflows = 3,72,600 × 4.968 (annuity factor, 8 years) = 18,51,076.80; PV of the new machine's salvage = 48,000 × 0.404 = 19,392; total 18,70,468.80. NPV = 18,70,468.80 − 9,60,000 = ₹9,10,468.80.
Advice. The NPV is strongly positive, so LMN Ltd. should replace the existing machine.
Where the 15 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Cash profit of each machine and the increment | 4 |
| 2 | Depreciation and incremental depreciation | 2 |
| 3 | Annual cash inflow after tax | 3 |
| 4 | Net cash outlay | 2 |
| 5 | NPV and advice | 4 |
| Total | 15 |
Report a problemopens an email to admin@getkunji.com with the question ID7867-Q2ORalready filled in.