Question 2 (b)

Should the old machine be replaced?

12 marks

Time to write: About 24 minutes
Topic: Capital budgeting process and cash flow estimation

Question

Question 2 (b) · 12 marks

Ruby Ltd. has a machine which was bought five years ago for Rs. 12,00,000 has a book value of Rs. 4,80,000 and has a remaining useful life of five years. A new machine is available at a cost of Rs. 24,00,000. It has the same capacity as the old machine but will save variable cost of Rs. 8,40,000 per annum. The new machine, too, has a life of five years, after which it can be sold for Rs. 2,40,000. The income tax rate of 40% applies to revenue as well as capital income, and the return expected on investment is 12% p.a. If sold today, the old machine will realise Rs. 1,20,000, and it will have no salvage value five years from now. The straight line method of depreciation is to be used. Advise whether or not the company should replace the old machine with the new one?

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

24 minfor 12 marks

Read from the question

replaceCash flows year by year in one table, then discount, then a one-line decision.

What the paper leaves open

The paper says the 40% tax applies to capital income as well as revenue. It is read as applying to the loss on selling the old machine below its book value, so that loss saves tax.

Write it in this order

Read the data; note exactly what is asked 2 min
1 Net initial outlay, including the tax saved on the loss on sale 3 marks 5 min
2 Incremental depreciation 2 marks 3 min
3 Incremental cash flows after tax 3 marks 5 min
4 Present values including salvage 2 marks 3 min
5 NPV and advice 2 marks 3 min
Check: arithmetic, units (₹, %), final answer underlined 3 min

12345

Short on time? End with step 5's one-line decision, whatever happens: never leave the figures without it.

Try it first. About 24 minutes for 12 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.

1. Net initial outlay

	₹
Cost of the new machine	24,00,000
Less: sale value of the old machine	(1,20,000)
Less: tax saved on the loss on sale (4,80,000 − 1,20,000 = 3,60,000 × 40%)	(1,44,000)
Net initial outlay	21,36,000

The loss on selling the old machine below its book value saves tax at 40%, since the paper applies the tax rate to capital income as well (paper note).

2. Incremental annual cash flow (years 1–5)

	₹
Saving in variable cost	8,40,000
Less: incremental depreciation: new (24,00,000 − 2,40,000) ÷ 5 = 4,32,000; old 4,80,000 ÷ 5 = 96,000	3,36,000
Incremental profit before tax	5,04,000
Less: tax @ 40%	2,01,600
Incremental profit after tax	3,02,400
Add: incremental depreciation	3,36,000
Incremental cash flow after tax	6,38,400

3. Present value at 12% (the new machine's salvage of ₹2,40,000 equals its book value then, so there is no tax on it; the old machine would have no salvage)

Year	Cash flow (₹)	PV factor @ 12%	Present value (₹)
1	6,38,400	0.893	5,70,091.20
2	6,38,400	0.797	5,08,804.80
3	6,38,400	0.712	4,54,540.80
4	6,38,400	0.636	4,06,022.40
5	6,38,400	0.567	3,61,972.80
5 (salvage)	2,40,000	0.567	1,36,080.00
		Total PV	24,37,512.00

4. NPV and advice

	₹
Present value of incremental inflows	24,37,512
Less: net initial outlay	21,36,000
NPV	3,01,512

The NPV of replacing at 12% is positive (₹3,01,512). The company should replace the old machine with the new one.

Where the 12 marks sit

#	Component	Marks
1	Net initial outlay, including the tax saved on the loss on sale	3
2	Incremental depreciation	2
3	Incremental cash flows after tax	3
4	Present values including salvage	2
5	NPV and advice	2
	Total	12

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