X Ltd. has a machine having an additional life of 5 years, which costs ₹2,00,000 and has a book value of ₹80,000. A new machine costing ₹4,00,000 is available. Though its capacity is the same as that of the old machine,

CS Executive · Financial and Strategic Management · PYQS · December 2018
X Ltd. has a machine having an additional life of 5 years, which costs ₹2,00,000 and has a book value of ₹80,000. A new machine costing ₹4,00,000 is available. Though its capacity is the same as that of the old machine, it will mean a saving in variable costs to the extent of ₹1,40,000 per annum. The life of the machine will be 5 years at the end of which it will have a scrap value of ₹40,000. The rate of income tax is 46% and it is the policy of the company not to make an investment if the yield is less than 12% per annum. The old machine, if sold today, will realise ₹20,000; and will have no salvage value if sold at the end of 5th year. Advise X Ltd. whether or not the old machine should be replaced. Assume capital gain to be tax free and ignore income tax saving on depreciation as well as on loss due to sale of existing machine.

Answer & Explanation:

Answer 4(b) Net cash outlay on new machine ₹ Purchase price 4,00,000 Less: realization from old machine (20,000) New initial investment 3,80,000 Cash inflows ₹ Annual savings in variable cost as a result of purchase of new machine 1,40,000 Less: Tax @ 46% (64,400) Annual savings after tax 75,600 PV of cash inflows annually for 5 years @ 12% p.a. (75,600 x 3.6048) 2,72,523 PV of salvage (40,000 x 0.5674) 22,696 Total PV of cash inflows 2,95,219 Less: Initial investment (3,80,000) Net present value (84,781) Since the net present value of the new machine is negative, the company should not replace the existing machine.

Topics: Financial Management

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