HCP Ltd. is a leading manufacturer of railway parts for passenger coaches and freight wagons. Due to high wastage of material and quality issues in…

CA Intermediate · Financial Management and Strategic Management · PYQS · May 2024
HCP Ltd. is a leading manufacturer of railway parts for passenger coaches and freight wagons. Due to high wastage of material and quality issues in production, the General Manager of the company is considering the replacement of machine A with a new CNC machine B. Machine A has a book value of 4,80,000 and remaining economic life is 6 years. It could be sold now at 1,80,000 and zero salvage value at the end of sixth year. The purchase price of Machine B is 24,00,000 with economic life of 6 years. It will require - 1,40,000 for installation and - 60,000 for testing. Subsidy of 15% on the purchase price of the machine B will be received from Government at the end of 1st year. Salvage value at the end of sixth year will be - 3,20,000. The General manager estimates that the annual savings due to installation of machine B include a reduction of three skilled workers with annual salaries of 1,68,000 each, 4,80,000 from reduced wastage of materials and defectives and - 3,50,000 from loss in sales due to delay in execution of purchase orders. Operation of Machine B will require the services of a trained technician with annual salary of 3,90,000 and annual operation and maintenance cost will increase by - 1,54,000. The company's tax rate is 30% and it's required rate of return is 14%. The company follows straight line method of depreciation. Ignore tax savings on loss due to sale of existing machine. The present value factors at 14% are: Years 0 1 2 3 4 5 6 PV Factor 1 0.877 0.769 0.675 0.592 0.519 0.456 Required: (i) Calculate the Net Present Value and Profitability Index and advise the company for replacement decision. (ii) Also calculate the discounted pay-back period.

Suggested Answer and Working Notes:

Calculation of Net Initial Cash Outflows: Particulars ₹ Cost of new machine 24,00,000 Less: Sale proceeds of existing machine (1,80,000) Add: Installation 1,40,000 Add: Testing 60,000 Less: Subsidy from government (15% of 24,00,000) x 0.877 (3,15,720) Net initial cash outflows 21,04,280 Calculation of Incremental Depreciation Particulars ₹ Depreciation on existing machine (4,80,000/6) (i) 80,000 Depreciation base of New Machine Cost of new machine 24,00,000 Add: Installation 1,40,000 Add: Testing 60,000 Less: Subsidy from government (3,60,000) Less: Salvage value at the end of 6 th year (3,20,000) Depreciation base of New Machine 19,20,000 Depreciation on New Machine (19,20,000/6) (ii) 3,20,000 Incremental depreciation [(ii) – (i)] 2,40,000 Computation of Annual Operating Cash flow after tax (CFAT) Particulars Amount (₹) Amount (₹) Savings in cost Cost of 3 skilled workers (₹ 1,68,000 x 3) 5,04,000 Reduced wastage of material 4,80,000 Saving in loss of sales 3,50,000 Total 13,34,000 Less: Increase in cost Salary to trained technician 3,90,000 Increase in annual operation and maintenance cost 1,54,000 Total (5,44,000) Incremental Saving before tax and depreciation 7,90,000 Less: Incremental Depreciation (2,40,000) Incremental PBT 5,50,000 Less: Tax @30% (1,65,000) PAT 3,85,000 Add: Depreciation 2,40,000 Incremental CFAT 6,25,000 Calculation of NPV Particulars Year Net Cashflow (₹) PVF @ 14% PV (₹) Net initial cash outflows 0 (24,20,000) 1 (21,04,280) Incremental CFAT 1 to 6 6,25,000 3.888 24,30,000 Salvage Value of New Machine 6 3,20,000 0.456 1,45,920 PV of inflows = 25,75,920 Net Present Value = 4,71,640 Profitability Index = Sum of discounted cash inflows Initial cash outlay or Total discounted cash outflow (as the case may) = 25,75,920/21,04,280 = 1.224 Advise: Since the NPV is positive and PI is greater than 1, the company should replace the machine Computation of Discounted Payback Period Year Cashflow PVF @ 14% PV of CFs (₹) Cumulative PV (₹) 1 6,25,000 0.877 5,48,125 5,48,125 2 6,25,000 0.769 4,80,625 10,28,750 3 6,25,000 0.675 4,21,875 14,50,625 4 6,25,000 0.592 3,70,000 18,20,625 5 6,25,000 0.519 3,24,375 21,45,000 6 9,45,000 0.456 4,30,920 25,75,920 Discounted Payback Period = 4 + 21,04,280 - 18,20,625 3,24,375 = 4.87 years If we take subsidy in cash inflow of 1 st year, then solution can also be done in the following way: Calculation of Net Initial Cash Outflows: Particulars ₹ Cost of new machine 24,00,000 Less: Sale proceeds of existing machine (1,80,000) Add: Installation 1,40,000 Add: Testing 60,000 Net initial cash outflows 24,20,000 Note: However, Incremental Depreciation and CFAT will remain same. Calculation of NPV Particulars Year Net Cashflow (₹) PVF @ 14% PV (₹) Net initial cash outflows 0 (24,20,000) 1 (24,20,000) Subsidy 1 3,60,000 0.877 3,15,720 Incremental CFAT 1 to 6 6,25,000 3.888 24,30,000 Salvage Value of New Machine 6 3,20,000 0.456 1,45,920 PV of inflows = 28,91,640 Net Present Value = 4,71,640 Profitability Index = Sum of discounted cash in flows Initial cash outlay or Total discounted cash outflow (as the case may) = 28,91,640 /24,20,000 = 1.195 Advise: Since the NPV is positive and PI is greater than 1, the company should replace the machine Computation of Discounted Payback Period Year Cashflow PVF @ 14% PV of CFs (₹) Cumulative PV (₹) 1 9,85,000 0.877 8,63,845 8,63,845 2 6,25,000 0.769 4,80,625 13,44,470 3 6,25,000 0.675 4,21,875 17,66,345 4 6,25,000 0.592 3,70,000 21,36,345 5 6,25,000 0.519 3,24,375 24,60,720 6 9,45,000 0.456 4,30,920 28,91,640 Discounted Payback Period = 4 + 24,20,000-21,36,345 3,24,375 = 4.87 years

Topics: Part-A: Financial Management

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