Question 3.PP.29: Assume everything to be the same as contained in P3.28, exce......
Assume everything to be the same as contained in P3.28, except that the firm follows written down value method of depreciation at the rate of 25 per cent. Assume further that the company does not have any other asset in the block of 25 per cent and the machine is expected to have salvage value of Rs 5 lakh at year-end 5. Does your answer change? You are to compute NPV in real terms.
There will be a change in PV of tax savings due to depreciation in view of change in the method of depreciation; there will be tax savings due to short-term capital loss at year-end 5 also.
Recommendation: Since NPV is positive, the firm should accept the project. The answer regarding acceptance of the project remains unchanged.
| CFAT,\>Real | Discount\>factor at \>0.06 |
Tax\>savings/Nominal CFAT,\> (Depreciation × 0.35) |
Depreciation | Year |
| Rs 4,12,562 | 0.943 | Rs 4,37,500 | Rs 12,50,000 | 1 |
| 2,92,031 | 0.890 | 3,28,125 | 9,37,500 | 2 |
| 2,06,719 | 0.840 | 2,46,094 | 7,03,125 | 3 |
| 1,46,179 | 0.792 | 1,84,570 | 5,27,344 | 4* |
* Since the block ceases to exist in the 5th year, no depreciation is charged in year 5.
Present\> value \>of\>tax \>shield,\> salvage \>value\> and\> short-term \>capital\> loss
| Total\>PV | PV\>factor\>0.10 | Real\>CFAT | Year |
| Rs 3,75,019 | 0.909 | Rs 4,12,562 | 1 |
| 2,41,218 | 0.826 | 2,92,031 | 2 |
| 1,55,246 | 0.751 | 2,06,719 | 3 |
| 99,840
|
0.683 | 4 1,46,179 | |
| 8,71,323
|
(i) Present\>value\> of\> tax\> shield\> due\> to\> depreciation | ||
| Salvage value (at year-end 5) | |||
| Rs 5,00,000 | Salvage value | ||
| (×) 0.747
|
(X) Deflated/discount factor at 0.06 (at year-end 5) | ||
| 3,73,500 | Real Cash inflows | ||
| (×) 0.621
|
(X) Discount factor (at year-end 5) at 0.10 | ||
| 2,31,943
|
(ii) Present\>value \>of \>salvage\> value | ||
| Short-term capital loss (at year-end 5) | |||
| 50,00,000 | Cost of machine | ||
| 34,17,969
|
Less accumulated depreciation in 4 years | ||
| 15,82,031 | Book value of machine in year 5 | ||
| 50,00,000
|
Less sale value | ||
| 10,82,031 | Short-term capital loss (STCL) | ||
| 3,78,711 | Tax savings (Rs 10,82,031 × 0.35) on STCL/CFAT, nominal | ||
| (×) 0.747
|
(X) Deflation factor at 0.06 (at year-end 5) | ||
| 2,82,897 | Real CFAT | ||
| (×) 0.621
|
(X) Discount factor (at year-end 5) at 0.10 | ||
| 1,75,679
|
(iii) Present\>value\>of\>STCL | ||
| 12,78,945 | Total present value (Rs 8,71,323 + Rs 2,31,943 + Rs 1,75,679) | ||
| Rs 49,28,300 | Present value of operating CFAT |
| 4,63,887 | Present value of release of working capital |
| 12,78,945
|
Present value of tax shield due to depreciation, salvage value and short-term capital loss |
| 66,71,132 | Total present value |
| 60,00,000
|
Less present value of cash outflows |
| 6,71,132 | Net present value |