HMR Ltd. is considering replacing a manually operated old machine with a fully automatic new machine. The old machine had been fully depreciated for…

CA Intermediate · Financial Management and Strategic Management · RTP · May 2024
HMR Ltd. is considering replacing a manually operated old machine with a fully automatic new machine. The old machine had been fully depreciated for tax purpose but has a book value of 2,50,000 on 31 st March. The machine has begun causing problems with breakdowns and it cannot fetch more than - 40,000 if sold in the market at present. It will have no realizable value after 10 years. The company has been offered - 1,50,000 for the old machine as a trade in on the new machine which has a price (before allowance for trade in) of 6,00,000. The expected life of new machine is 10 years with salvage value of 35,000. Further, the company follows written down value method depreciation @ 10% but for tax purpose, straight line method depreciation is used considering that this is the only machine in the block of assets. A working capital of 50,000 will be needed and it will be released at the end of tenth year. Given below are the expected sales and costs from both old and new machine: Old machine New machine Annual output 60,000 units 80,000 units Selling price per unit 18 18 Annual operating hours 2,800 2,800 Material cost per unit 5 5 Labour cost per hour 50 75 Indirect cash cost per annum 1,00,000 1,75,000 From the above information, ANALYSE whether the old machine should be replaced or not if the opportunity cost of capital of the Company is 10%? The Income tax rate is 30%. Further assume that book profit is treated as ordinary income for tax purpose. Also ESTIMATE the internal rate of return of the replacement decision. All calculations to be calculated to 3 decimal places.

Suggested Answer and Working Notes:

Workings: (i) Initial Cash Outflow: Amount (₹) Cost of new machine 6,00,000 Less: Sale Price of existing machine 1,05,000 Net of Tax (₹ 1,50,000 × 0.70) 4,95,000 (ii) Terminal Cash Flows: New Machine Amount (₹) Salvage value of Machine 35,000 Less: Depreciated WDV {6,00,000 - (₹ 56,500 × 10 years)} 35,000 Short Term Capital Gain (STCG) Nil Tax Nil Net Salvage Value (cash flows) 35,000 (iii) Computation of additional cash flows (yearly) Particulars Existing machine New Machine Incremental (1) (2) (3) (4)=(3)-(2) Annual output 60,000 units 80,000 units 20,000 units ₹ ₹ ₹ (A) Sales revenue @18 per unit 10,80,000 14,40,000 3,60,000 (B) Less: Cost of Operation Material @5 per unit 3,00,000 4,00,000 1,00,000 Labour Old = 2,800 x 50 1,40,000 70,000 New = 2,800 x 75 2,10,000 Indirect cash cost 1,00,000 1,75,000 75,000 Total Cost (B) 5,40,000 7,85,000 2,45,000 Profit Before Tax and depreciation (PBTD) (A - B) 5,40,000 6,55,000 1,15,000 Less: Depreciation (6,00,000-35,000)/10 56,500 Earning after depreciation before Tax 58,500 Less: Tax @30% 17,550 Earning after depreciation and Tax 40,950 Add: Depreciation 56,500 Net Cash inflow 97,450 Analysis: Since the Incremental Cash flow is positive, the old machine should be replaced. Note: As mentioned in the question WDV of Machine is zero for tax purpose hence no depreciation shall be provided in existing machine. (iv) Calculation of IRR Computation of NPV @ 10% Period Cash flow (₹) PVF @ 10% PV (₹) Incremental cash flows 1-10 97,450 6.144 5,98,733 Add: Release of Working Capital 10 50,000 0.386 19,300 Add: Terminal year cash 10 35,000 0.386 13,510 6,31,543 Less: Initial cash outflow 0 4,95,000 1 4,95,000 Less: Working capital 0 50,000 1 50,000 NPV 86,543 Since NPV computed in Part (i) is positive. Let us discount cash flows at higher rate say at 20% Period Cash flow (₹) PVF @ 20% PV (₹) Incremental cash flows 1-10 97,450 4.192 4,08,510 Add: Release of Working Capital 10 50,000 0.162 8,100 Add: Terminal year cash 10 35,000 0.162 5,670 4,22,280 Less: Initial cash outflow 0 4,95,000 1 4,95,000 Less: Working capital 0 50,000 1 50,000 NPV (1,22,720) Now we use interpolation formula: IRR = 10% + [86,543 / (86,543 - (-1,22,720))] × 10% IRR = 10% + [86,543 / 2,09,263] × 10% IRR = 10% + 4.14% = 14.14% Summary of Results Decision Incremental Cash Flow - 97,450 Accept IRR 14.14% > Cost of Capital (10%) Accept

Topics: Part-A: Financial Management

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