Question 5.S2.RQ.23: A toy manufacturing company is considering replacing an exis......
A toy manufacturing company is considering replacing an existing piece of equipment with one of the two new, more sophisticated machines. The old machine was purchased 3 years ago at a cost of Rs 70,000. The machine originally had a projected life of 7 years and was to be depreciated straight line to zero salvage value. The two new pieces of equipment being considered are machine X and machine Y.
Machine X would cost Rs 80,000 to purchase, and Rs 20,000 to install. Due to expansion in operation, the management estimates the net working capital requirement of machine X at Rs 10,000. It has a 4-year life with no salvage value. It will be depreciated straight line.
Machine Y would cost Rs 1,15,000 and Rs 25,000 to install. It also has 4-year life with no salvage value. This machine would require a net working capital of Rs 20,000.
The old machine can be sold for Rs 25,000 on 1 year credit. The firm is taxed at 35 per cent. Assuming the cost of capital to be 10 per cent, which machine, if either, should the company acquire? The projected profits before depreciation and taxes currently and with each of the new machines are as follows:
What would be your answer, if the company has under consideration only the proposal to purchase machine X?
| Year | With present Machine | With Machine X | With Machine Y |
| 1 | Rs 25,000 | Rs 50,000 | Rs 90,000 |
| 2 | 25,000 | 50,000 | 90,000 |
| 3 | 25,000 | 50,000 | 90,000 |
| 4 | 25,000 | 50,000 | 90,000 |
Cash outflows
Working Notes
*Cash inflows from the sale of the present machine:
Cash inflows (t = 1 – 4)
The company should acquire machine Y. If the company has the proposal to buy machine X only, then it should continue with the existing machine.
| Particulars | Machine X | Machine Y |
| Cost of the machine | Rs 80,000 | Rs 1,15,000 |
| Add installation cost | 20,000 | 25,000 |
| Add net working capital | 10,000 | 20,000 |
| Less cash inflows from the sale of the present machine | 27,975* | 27,975* |
| Net cash outflows | 82,025 | 1,32,025 |
| Book value of the machine (Rs 70,000 – Rs 30,000, accumulated depreciation) | Rs 40,000 |
| Less sale value | 25,000 |
| Short-term capital loss on the sale of the machine | 15,000 |
| Tax savings on loss (0.35) | 5,250 |
| PV of Rs 25,000 to be received at (t = 1) = (Rs 25,000 x 0.909) | 22,725 |
| 27,975 |
| Particulars | Present machine | Machine X | Machine Y |
| Earning befor depreciation and taxes | Rs 25,000 | Rs 50,000 | Rs 90,000 |
| Less depreciation | 10,000 | 25,000 | 35,000 |
| Net earnings | 15,000 | 25,000 | 55,000 |
| Less Taxes | 5,250 | 8,750 | 19,250 |
| EAT 9,750 | 16,250 | 35,750 | |
| Add depreciation | 10,000 | 25,000 | 35,000 |
| CFAT19,750 | 41,250 | 70,750 | |
| × PV factor | 3.170 | 3.170 | 3.170 |
| Total PV of CFAT | 62,607 | 1,30,762 | 2,24,277 |
| PV of the release of WC (PV factor = 0.683) | — | 6,830 | 13,660 |
| Total PV | 62,607 | 1,37,592 | 2,37,937 |
| Less cash outflows | — | 82,025 | 1,32,025 |
| NPV | 62,607 | 55,567 | 1,05,912 |