Question 2 OR
Replacement decision from after-tax profits
15 marks
- Time to write
- About 30 minutes
From an older CBCS paper
Question
Question 2 OR · 15 marks- A company is considering replacing a machine that originally cost ₹60.000. The machine's current book value is nil, and it can be used for another 6 years, after which its salvage value will be zero. The new machine costs ₹2,52,000, and ₹36,000 must be spent to install it. New machine is also likely to have a life of 6 years, with no salvage value. The profits projected from the existing and the new machine are below:
| Year | Existing Machine (₹): after tax profit expected | New Machine (₹): after tax profit expected |
|---|---|---|
| 1 | 2,40,000 | 2,88,000 |
| 2 | 3,00,000 | 3,72,000 |
| 3 | 3,72,000 | 4,20,000 |
| 4 | 4,32,000 | 4,92,000 |
| 5 | 4,92,000 | 5,16,000 |
| 6 | 6,00,000 | 6,12,000 |
The tax rate is 40%, and the company follows the straight line method of depreciation. The Cost of capital is 12%. If the new machine is bought, the existing one can be sold for ₹30,000. Should the finance manager replace the machine? Advise, using the Net Present Value method.
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
- Should…?Advise…Two asks in one question: answer both.
- Should the finance…?A yes-or-no question: answer it in your first line, then explain why.
- replacingCash flows year by year in one table, then discount, then a one-line decision.
What the paper leaves open
"₹60.000" is read as ₹60,000, the old machine's original cost; it is fully depreciated, so its sale proceeds are taxed in full as a gain only if the paper says so, and here no tax is charged on the sale (C7). The profits given are after tax; depreciation is added back to reach cash flows.
Write it in this order
- Read the data; note exactly what is asked 2 min
- 1 Readings and net cash outlay 3 marks 6 min
- 2 Depreciation 2 marks 4 min
- 3 Incremental cash flows 5 marks 9 min
- 4 Present values and NPV 3 marks 6 min
- 5 Advice 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.
Readings (paper note). "₹60.000" is the old machine's original cost, ₹60,000; it is fully depreciated (book value nil), so it carries no further depreciation, and its sale for ₹30,000 is taken without tax. The profits given are after tax; depreciation is added back to reach cash flows.
Net cash outlay. For a replacement, the new machine's cost (with installation) less the sale proceeds of the old one: (2,52,000 + 36,000) − 30,000 = ₹2,58,000.
Depreciation on the new machine = 2,88,000 ÷ 6 = ₹48,000 a year (none on the old).
Incremental cash flows and NPV at 12%
| Year | PAT, new | PAT, existing | Incremental PAT | Add: depreciation | Incremental cash flow | PVF @ 12% | PV |
|---|---|---|---|---|---|---|---|
| 1 | 2,88,000 | 2,40,000 | 48,000 | 48,000 | 96,000 | 0.893 | 85,728 |
| 2 | 3,72,000 | 3,00,000 | 72,000 | 48,000 | 1,20,000 | 0.797 | 95,640 |
| 3 | 4,20,000 | 3,72,000 | 48,000 | 48,000 | 96,000 | 0.712 | 68,352 |
| 4 | 4,92,000 | 4,32,000 | 60,000 | 48,000 | 1,08,000 | 0.636 | 68,688 |
| 5 | 5,16,000 | 4,92,000 | 24,000 | 48,000 | 72,000 | 0.567 | 40,824 |
| 6 | 6,12,000 | 6,00,000 | 12,000 | 48,000 | 60,000 | 0.507 | 30,420 |
| Total PV | 3,89,652 |
NPV = 3,89,652 − 2,58,000 = ₹1,31,652.
Advice. The NPV of replacement is positive, so the finance manager should replace the machine. (The tax rate of 40% is already reflected in the after-tax profits given.)
Where the 15 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Readings and net cash outlay | 3 |
| 2 | Depreciation | 2 |
| 3 | Incremental cash flows | 5 |
| 4 | Present values and NPV | 3 |
| 5 | Advice | 2 |
| Total | 15 |
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