Pawan Ltd. has a machine having a balance economic life of five years, which costed ₹2,00,000 and has a book value of ₹80,000. A new machine with same capacity, costing ₹4 lakh is available in the market. One of the esti

CS Professional · Financial, Treasury and Forex Management · PYQS · December 2019
Pawan Ltd. has a machine having a balance economic life of five years, which costed ₹2,00,000 and has a book value of ₹80,000. A new machine with same capacity, costing ₹4 lakh is available in the market. One of the estimates from technical personnel indicated, that through the acquisition of a new machine, a saving in variable cost can accrue to the extent of ₹1,40,000 per annum. The economic life of the new machine will be 5 years, and can fetch a scrap value of ₹40,000. The rate of income tax would be 46% including cess, and other taxes, as envisaged. The management has fixed the soft capital rationing at the rate of 12% per annum. If the old machine sold today, it would be result in realisation of ₹20,000, and will have zero value after five years from now. For the working, you can assume no capital gain tax applicable. You can also ignore the income tax savings on account of depreciation as well as loss on sale of existing machine. You are required to advise the management, whether to replace the machine or not, as on date ?

Answer & Explanation:

Evaluation of Replacement Decision using Net Present Value (NPV) Cost of New Machine: Purchase Price of New Machine = ₹4,00,000 Less: Realization from sale of old machine = ₹20,000 Net Cash Outlay (Initial Investment) = ₹3,80,000 Annual Cash Inflows: Annual Savings in Variable Cost = ₹1,40,000 Less: Tax @ 46% = 46% of ₹1,40,000 = ₹64,400 Annual Savings After Tax = ₹75,600 Present Value of Cash Inflows: Economic life of new machine = 5 years Capital rationing rate (Discount Rate) = 12% PV of an annuity of ₹1 for 5 years at 12% (from table) = 3.6048 PV of Annual Savings = ₹75,600 * 3.6048 = ₹2,72,523 Present Value of Salvage Value: Scrap Value of New Machine = ₹40,000 PV of ₹1 for 5 years at 12% (from table) = 0.5674 PV of Salvage Value = ₹40,000 * 0.5674 = ₹22,696 Total Present Value of Cash Inflows = PV of Annual Savings + PV of Salvage Value Total Present Value of Cash Inflows = ₹2,72,523 + ₹22,696 = ₹2,95,219 Net Present Value (NPV) = Total Present Value of Cash Inflows - Net Cash Outlay NPV = ₹2,95,219 - ₹3,80,000 = (₹84,781) Advice to Management: Since the Net Present Value (NPV) is negative (₹84,781), it is advised to the company not to replace the existing machine, as the replacement project is not financially viable.

Topics: Capital Budgeting

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