Question 3.PP.28: Royal Industries is contemplating on buying a new moulding m......

Management Accounting and Financial Analysis for CA Final Examination [995093]

Royal Industries is contemplating on buying a new moulding machine at Rs 50 lakh, with an additional working capital requirement of Rs 10 lakh. The machine is expected to have an economic useful life of 5 years, with no salvage value. The firm follows the straight-line method of depreciation and the same is accepted for tax purposes. The machine is expected to generate an incremental increase in the before tax cash operating income of Rs 20 lakh (in real terms) per year for a period of 5 years. The relevant tax rate is 35 per cent. Inflation is expected to be 6 per cent per year and the firm’s cost of capital in real terms is 10 per cent. Advise the company whether the machine should be purchased. Show your NPV calculation in real terms. Assume the working capital requirement will remain unchanged throughout the period, in spite of inflation.

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(d) Release of working capital (at year-end 5) $\,$ Rs 10,00,000
$\,$ (X) Discount factor at 0.06 (at year-end 5) $\frac{(×) 0.747}{}$
$\,$ Cash inflows (real) $\,$ 7,47,000
$\,$ (X) Discount factor at 0.10 (at year-end 5) $\frac{(×) 0.621}{}$
$\,$ Present value $\frac{4,63,887}{}$
(iii) Total present value
$\,$ (a) Rs 49,28,300 + (c) Rs 11,29,796 + (d) Rs 4,63,887 $\frac{65,21,983}{}$
(iv) Net present value (Rs 65,21,983 – Rs 60,00,000) $\,$ 5,21,983
Recommendation: The company should purchase the machine as the NPV of real cash flows is positive.

(i) $Cash\> outflows$
Rs 50,00,000	Cost of moulding machine
10,00,000	Additional working capital
$\frac{60,00,000}{}$
(ii) $CFAT\> and \>Present \>value$
20,00,000	(a) Incremental cash operating income
7,00,000	Less taxes (0.35)
13,00,000	CFAT (t = 1 – 5)
(×) 3.791	(X) PV factor of annuity for 5 years (0.10)
49,28,300	Present value
(b) Tax savings due to depreciation
10,00,000	Depreciation (Rs 50 lakh/5 years) per year
(×) 0.35	(X) Tax rate (0.35)
3,50,000	Tax savings per year for 5 years

(c) \>Present\> value \>of \>tax \>shield \>due\> to\> depreciation

$Total\>PV$ $\,$	$PVF\>at\>0.10$ $\,$	$CFAT\>(Real)$ $\,$	$Discount/Deflated\>at$ $0.06\>rate\>of\>inflation$ *	$Tax\>savings$ $(Nominal\>CFAT)$	$Year$ $\,$
Rs 3,00,015	0.909	Rs 3,30,050	0.943	Rs 3,50,000	1
2,57,299	0.826	3,11,500	0.890	3,50,000	2
2,20,794	0.751	2,94,000	0.840	3,50,000	3
1,89,328	0.683	2,77,200	0.792	3,50,000	4
1,62,360	0.621	2,61,450	0.747	3,50,000	5
11,29,796	Present value

*As per Table A-3
Table A-3 The Present Value of One Rupee

$10\%$	$9\%$	$8\%$	$7\%$	$6\%$	$5\%$	$4\%$	$3\%$	$2\%$	$1\%$	$Year$
.909	.917	.926	.935	.943	.952	.962	.971	.980	0.990	1
.826	.842	.857	.873	.890	.907	.925	.943	.961	0.980	2
.751	.772	.794	.816	.840	.864	.889	.915	.942	.971	3
.683	.708	.735	.763	.792	.823	.855	.888	.924	.961	4
.621	.650	.681	.713	.747	.784	.822	.863	.906	.951	5
.564	.596	.630	.666	.705	.764	.790	.837	.888	.942	6
.513	.547	.583	.623	.665	.711	.760	.813	.871	.933	7
.467	.502	.540	.582	.627	.677	.731	.789	.853	.923	8
.424	.460	.500	.544	.592	.645	.703	.766	.837	.914	9
.386	.422	.463	.508	.558	.614	.676	.744	.820	.905	10
.350	.388	.429	.475	.527	.585	.650	.722	.804	.896	11
.319	.356	.397	.444	.497	.575	.625	.701	.789	.887	12
.290	.326	.368	.415	.469	.530	.601	.681	.773	.879	13
.263	.299	.340	.388	.442	.505	.577	.661	.758	.870	14
.239	.275	.315	.362	.417	.481	.555	.642	.743	.861	15
.218	.252	.292	.339	.394	.458	.534	.623	.728	.853	16
.198	.231	.270	.317	.371	.436	.513	.605	.714	.844	17
.180	.212	.250	.296	.350	.416	.494	.587	.700	.836	18
.164	.194	.232	.227	.331	.396	.475	.570	.686	.828	19
.149	.178	.215	.258	.312	.377	.456	.554	.673	.820	20
.135	.164	.199	.242	.294	.359	.439	.538	.660	.811	12
.123	.150	.184	.226	.278	.342	.422	.522	.647	.803	22
.112	.138	.170	.211	.262	.326	.406	.507	.634	.795	23
.102	.126	.158	.197	.247	.310	.390	.492	.622	.788	24
.092	.116	.146	.184	.233	.295	.375	.478	.610	.780	25
.057	.075	.099	.131	174	.231	.308	.412	.552	.742	30
.036	.049	.068	.094	.130	.181	.253	.355	.500	.706	35
.022	.032	.046	.067	.097	.142	.208	.307	.453	.672	40
.014	.021	.031	.048	.073	.111	.171	.264	.410	.639	45
.009	.013	.021	.034	.054	.087	.141	.228	.372	.608	50

(Contd.)

$20\%$	$19\%$	$18\%$	$17\%$	$16\%$	$15\%$	$14\%$	$13\%$	$12\%$	$11\%$	$Year$
.833	.840	.847	.855	.862	.870	.877	.885	.893	.901	1
.694	.706	.718	.731	.743	.756	.769	.783	.797	.812	2
.579	.593	.609	.624	.641	.658	.675	.693	.712	.731	3
.482	.499	.516	.534	.552	.572	.592	.613	.636	.659	4
.402	.419	.437	.456	.476	.497	.519	.543	.567	.593	5
.335	.352	.370	.390	.410	.432	.456	.480	.507	.535	6
.279	.296	.314	.333	.354	.376	.400	.425	.452	.482	7
.233	.249	.266	.285	.305	.327	.351	.376	.404	.434	8
.194	.209	.225	.243	.263	.284	.308	.333	.361	.391	9
.162	.176	.191	.208	.227	.274	.270	.295	.322	.352	10
.135	.184	.162	.178	.195	.215	.237	.261	.287	.317	11
.112	.124	.137	.152	.168	.187	.208	.231	.257	.286	12
.093	.104	.116	.130	.145	.163	.182	.204	.229	.258	13
.078	.088	.099	.111	.125	.141	.160	.181	.205	.232	14
.065	.074	.084	.095	.108	.123	.140	.160	.183	.209	15
.054	.062	.071	.081	.093	.107	.123	.141	.163	.188	16
.045	.052	.060	.069	.080	.093	.108	.125	.146	.170	17
.038	.044	.051	.059	.069	.081	.095	.111	.130	.153	18
.031	.037	.043	.051	.060	.070	.083	.098	.116	.138	19
.026	.031	.037	.043	.051	.061	.073	.087	.104	.124	20
.022	.026	.031	.037	.044	.053	.064	.077	.093	.112	21
.018	.022	.026	.032	.038	.046	.056	.068	.083	.101	22
.015	.018	.022	.027	.033	.040	.049	.060	.074	.091	23
.013	.015	.019	.023	.028	.035	.043	.053	.066	.082	24
.010	.013	.016	.020	.024	.030	.038	.047	.059	.074	25
.004	.005	.007	.009	.012	.015	.020	.026	.033	.044	30
.002	.002	.003	.004	.006	.008	.010	.014	.019	.026	35
.001	.001	.001	.002	.003	.004	.005	.008	.011	.015	40
.000	.000	.001	.001	.001	.002	.003	.004	.006	.009	45
.000	.000	.000	.001	.001	.001	.001	.002	.003	.005	50

(Contd.)

$30\%$	$29\%$	$28\%$	$27\%$	$26\%$	$25\%$	$24\%$	$23\%$	$22\%$	$21\%$	$Year$
.769	.775	.781	.787	.794	.800	.806	.813	.820	.826	1
.592	.601	.610	.620	.630	.640	.650	.661	.672	.683	2
.455	.466	.477	.488	.500	.512	.524	.537	.551	.564	3
.350	.361	.373	.384	.397	.410	.423	.437	.451	.467	4
.269	.280	.291	.303	.315	.328	.341	.355	.370	.386	5
.207	.217	.227	.238	.250	.262	.275	.289	.303	.319	6
.159	.168	.178	.188	.198	.210	.222	.235	.249	.263	7
.123	.130	.139	.148	.157	.168	.179	.191	.204	.218	8
.094	.101	.108	.116	.125	.134	.144	.155	.167	.180	9
.073	.078	.085	.092	.099	.107	.116	.126	.137	.149	10
.056	.061	.066	.072	.079	.086	.094	.103	.112	.123	11
.043	.047	.052	.057	.062	.069	.076	.083	.092	.102	12
.033	.037	.040	.045	.050	.055	.061	.068	.075	.084	13
.025	.028	.032	.035	.039	.044	.049	.055	.062	.069	14
.020	.022	.025	.028	.031	.035	.040	.045	.051	.057	15
.015	.017	.019	.022	.025	.028	.032	.036	.042	.047	16
.012	.013	.015	.017	.020	.023	.026	.030	.034	.039	17
.009	.010	.012	.014	.016	.018	.021	.024	.028	.032	18
.007	.008	.009	.011	.012	.014	.017	.020	.023	.027	19
.005	.006	.007	.008	.010	.012	.014	.016	.019	.022	20
.004	.005	.006	.007	.008	.009	.011	.013	.015	.018	21
.003	.004	.004	.005	.006	.007	.009	.011	.013	.015	22
.002	.003	.003	.004	.005	.006	.007	.009	.010	.012	23
.002	.002	.003	.003	.004	.005	.006	.007	.008	.010	24
.001	.002	.002	.003	.003	.004	.005	.006	.007	.009	25
.000	.000	.001	.001	.001	.001	.002	.002	.003	.003	30
.000	.000	.000	.000	.000	.000	.001	.001	.001	.001	35
.000	.000	.000	.000	.000	.000	.000	.000	.000	.000	40
.000	.000	.000	.000	.000	.000	.000	.000	.000	.000	45
.000	.000	.000	.000	.000	.000	.000	.000	.000	.000	50