Parmarth Limited is a manufacturer of computers. Owing to recent developments in Artificial Intelligence (AI), it is planning to introduce AI in its…

CA Intermediate · Financial Management and Strategic Management · MTP · September 2024
Parmarth Limited is a manufacturer of computers. Owing to recent developments in Artificial Intelligence (AI), it is planning to introduce AI in its computer process. This would result into an estimated annual savings as follows: (i) Savings of 3,50,000 in production delays caused by inventory problem. (ii) Savings in Salaries of 5 employees with an annual pay of 4,20,000 per annum (iii) Reduction in Lost sales of 1,75,000 (iv) Gain due to timely billing is 3,25,000 The project would result in annual maintenance and operating costs as follows, which are to be paid in advance (at the beginning) YEAR 1 2 3 4 5 COST 1,80,000 2,00,000 1,20,000 1,10,000 1,30,000 Furthermore, the new system would need 2 AI specialists' professional drawing salaries of 6,50,000 per annum per person. The purchase price of the new system for installing AI into computers would involve an outlay of 21,50,000 and installation cost of 1,50,000. 75% of the total value for depreciation would be paid in the year of purchase and the balance would be paid at the end of the 1st year. The new system will be sold for 1,90,000. This is the only asset in the block for Income tax purpose. The life of the system would be 5 years with the hurdle rate of 12%. Depreciation will be charged at 40% on WDV basis, corporate tax rate is 25% and capital gains tax rate is at 20%. CALCULATE NPV and advise the management on the acceptability of the proposal. Also calculate ARR & PI.

Suggested Answer and Working Notes:

Calculation of Present value of cash inflows (PVCI) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Savings in cost due to Production Delays 3,50,000 3,50,000 3,50,000 3,50,000 3,50,000 Savings in Salaries 21,00,000 21,00,000 21,00,000 21,00,000 21,00,000 Reduction in lost sales 1,75,000 1,75,000 1,75,000 1,75,000 1,75,000 Gain due to timely billing 3,25,000 3,25,000 3,25,000 3,25,000 3,25,000 29,50,000 29,50,000 29,50,000 29,50,000 29,50,000 Less: Salary of Al specialists 13,00,000 13,00,000 13,00,000 13,00,000 13,00,000 Annual Maint. & Op Cost 1,80,000 2,00,000 1,20,000 1,10,000 1,30,000 NPBDT 14,70,000 14,50,000 15,30,000 15,40,000 15,20,000 (-) Depreciation 9,20,000 5,52,000 3,31,200 1,98,720 1,19,232 NPBT 5,50,000 8,98,000 11,98,800 13,41,280 14,00,768 (-) Tax @ 25% 1,37,500 2,24,500 2,99,700 3,35,320 3,50,192 NPAT 4,12,500 6,73,500 8,99,100 10,05,960 10,50,576 (+) Depreciation 9,20,000 5,52,000 3,31,200 1,98,720 1,19,232 (+) Annual Maint. & Op Cost 1,80,000 2,00,000 1,20,000 1,10,000 1,30,000 Gross Cash Inflows 15,12,500 14,25,500 13,50,300 13,14,680 12,99,808 (-) Annual Maint. & Op Cost actually paid 1,80,000 2,00,000 1,20,000 1,10,000 1,30,000 Net Cash Inflows -1,80,000 13,12,500 13,05,500 12,40,300 11,84,680 12,99,808 (+) Sale Value at the end of life 1,90,000 -1,80,000 13,12,500 13,05,500 12,40,300 11,84,680 14,89,808 PV Factor @ 12% 1 0.8929 0.7972 0.7118 0.6355 0.5674 PV of Cash Inflows -1,80,000 11,71,875 10,40,737 8,82,821 7,52,886 8,45,357 Total PV of Cash Inflows 45,13,675 Calculation of Present value of cash outflows (PVCO) As mentioned in the question, 75% of the depreciable value will be paid at the beginning. Depreciable value means purchase price plus the installation cost. Year 0 Year 1 Purchase Price & Installation Cost 17,25,000 5,75,000 PV Factor @ 12% 1 0.8929 PVCO 17,25,000 5,13,418 (2) Total PVCO = 22,38,418 (3) PV of Tax on Capital Gains (Only asset in the block) - 5 th Year end Capital Gains = Sale Price (-) Closing WDV at 5 th year = 1,90,000 (-) 1,78,848 = 11,152 Tax @ 20% on above = 2230.40 PV = 2,230.40 x 0.5674 = 1,266 Net PVCI = PVCI - PV of Tax on Capital Gains = 45,13,675 - 1,266 = 45,12,409 NPV = Net PVCI – PVCO = 45,12,409 - 22,38,418 = 22,73,991 (II) PI = PVCI / PVCO = 45,12,409/ 22,38,418 = 2.0158 (III) ARR = Average NPAT / Initial Investment = 8,08,327.2/23,00,000 x 100 = 35.145% Note – ARR is calculated based on Initial Investment, similarly it can be calculated based on Average Investment

Topics: Part-A: Financial Management

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