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Part 3 Estimation of Cash Flow in Capital Budgeting problems with solutions
9. Vikalpa Ltd is evaluating to
replace a semi manually operated machine with a fully automatic one. The existing
machine purchased 10 years ago, with book value of Rs. 1,60,000 has remaining
life of 10 years. Its Salvage value is Rs. 40,000. The current machine has
maintenance expense of Rs. 30,000. The company has been offered Rs. 1,00,000
for the old machine as a trade-in on the automatic model whose delivery price
(before allowance for trade-in) is 2,50,000. The estimated life of new machine
is 10 years salvage value being Rs.50,000. Installation cost of new machine
will be Rs. 50,000. The new machine will help in saving of Rs. 1,10,000 p.a. in
operations of the plant. No Maintenance costs are to be incurred by company as
it will be borne by seller of machine. The tax rate is 30% (applicable to both
revenue income as well as capital gains/losses). Depreciation on both machine
is on the basis of Straight line method throughout the life of both machines..
Find out the relevant cash flows.
Solution
Initial Cash Outflow = Purchase
price of asset + installation cost + Working Capital increase – Salvage/Scrap
value of old asset ± Tax on Capital
gain/loss on sale of old asset
In this case Salvage value/ trade in value of old asset is
Rs.1,00,000 and book value is Rs. 1,60,000. Hence there is a capital loss of
Rs. 60,000
Capital loss = Book value of asset – salvage value of asset
While calculating initial cash
outflow; Tax on capital loss on sale of asset is subtracted from initial cash
outflow and tax on capital gain on sale of asset is added to initial cash
outflow.
Initial cash outflow = Rs. 2,50,000 + Rs. 50,000 – Rs.
1,00,000 - 30 % of (Rs. 1,60,000 – Rs.
1,00,000) = Rs. 1,82,000
Cash inflow in all subsequent years will remain same as
incremental depreciation will remain same in all years. Hence there is no need
to calculate cash inflow for ten years. Cash inflow generated in first year
will be similar to cash inflow in other nine years. In tenth year, terminal
cash inflow will also be generated.
Depreciation on new
machine = Purchase price excluding allowance for trade in + installation
cost – salvage value / estimated life = (Rs. 2,50,000 + Rs. 50,000 – Rs.
50,000) / 10 = Rs. 25,000.
Depreciation on old
machine = (Book value of asset – salvage value) / estimated life
= (Rs. 1,60,000 – Rs. 40,000) / 10 = Rs. 12,000
Incremental
Depreciation = Depreciation on new machine - Depreciation on old machine
= Rs. 25,000 - Rs. 12,000 = Rs. 13,000
Calculation of subsequent cash inflow
|
|
Rs. |
|
Savings in maintenance |
30,000 |
|
Saving in operation of plant |
1,10,000 |
|
EBDT |
1,40,000 |
|
Less: Incremental Depreciation |
(13,000) |
|
EBT |
1,27,000 |
|
Less: Tax @ 30 % |
(38,100) |
|
PAT |
88,900 |
|
Add: Incremental Depreciation |
13,000 |
|
Net annual Cash inflow |
1,01,900 |
|
Terminal cash inflow |
Rs. 10,000 |
Calculation of
Terminal Cash inflow
Terminal cash inflow
= Salvage value of new machine – sacrifice of salvage value of old machine due
to its disposal in the beginning of the year
= Rs. 50,000 – Rs. 40,000 = Rs. 10,000
Note: Since calculation is based
on SLM, no capital gain or loss arises as book value of machine is nil at the
end of tenth year (For more details, refer to Income Tax Act, 1961). In case,
salvage value of old machine is greater than salvage value of new machine then
terminal cash inflow will be negative.
10. Vishnu ltd is considering
replacing its old machine costing Rs. 1, 60,000 having a written down value of Rs.
64,000. The remaining economic life of the plant is 4 years with zero salvage
value at the end of 4 years. However, it has current salvage value of Rs. 60,000
if disposed off today. The new machine being considered to replace old machine
is of Rs. 2,50,000 having an economic life of 4 years and salvage value of Rs.
50,000. The new machine, due to its technological superiority, is expected to
contribute additional annual benefit (before depreciation and tax) of Rs. 90,000.
Find out the cash flows associated with this decision. Tax rate is 30%. (Ignore
tax on capital gain or loss).
Solution
Cash outflow = Cost of new machine – scrap value of old
machine
= Rs. 2,50,000 – Rs. 60,000 = Rs. 190,000
Depreciation on new
machine = Purchase price– salvage value / estimated life
= (Rs. 2,50,000 – Rs. 50,000) / 4 = Rs. 50,000.
Depreciation on old
machine = (Book value of asset – salvage value) / estimated life
= Rs. 1,60,000 / 4 = Rs. 40,000
Incremental
Depreciation = Depreciation on new machine - Depreciation on old machine
= Rs. 50,000 - Rs. 40,000 = Rs. 10,000
Calculation of subsequent cash inflow
|
|
Rs. |
|
Incremental benefit (EBDT) |
90,000 |
|
Less: Incremental Depreciation |
(10,000) |
|
EBT |
80,000 |
|
Less: Tax @ 30 % |
(24,000) |
|
PAT |
64,000 |
|
Add: Incremental Depreciation |
10,000 |
|
Net annual Cash inflow |
74,000 |
|
Terminal cash inflow |
Rs. 50,000 |
Calculation of Terminal
cash inflow
Terminal cash inflow
= Salvage value of new machine – sacrifice of salvage value of old machine due
to its disposal in the beginning of the year
= Rs. 50,000 – 0 (salvage value of old machine is nil) =
Rs.50,000 .
|
|
Year 1 (Rs.) |
Year 2(Rs.) |
Year 3(Rs.) |
Year 4(Rs.) |
Year 5(Rs.) |
|
Existing Machine |
30,000 |
30,000 |
30,000 |
30,000 |
30,000 |
|
New Machine |
70,000 |
90,000 |
1,00,000 |
90,000 |
1,00,000 |
The company uses Straight Line
Method of depreciation. Tax on income as well as on capital gains/losses is
30%. Calculate the incremental cash flows assuming sale value of existing
machine: (i) Rs. 1,20,000, (ii) Rs. 60,000, (iii)Rs. 90,000 and (iv) Rs. 80,000.
Solution
Calculation of
incremental initial cash outflow in different cases
Initial Cash Outflow = Purchase
price of asset + installation cost + Working Capital increase – Salvage/Scrap
value of old asset ± Tax on Capital
gain/loss on sale of old asset
|
|
Case 1 Rs.1,20,000 |
Case 2 Rs.1,25,000 |
Case 3 Rs.90,000 |
Case 4 Rs.80,000 |
|
Cost of new machine including installation cost |
2,50,000 |
2,50,000 |
2,50,000 |
2,50,000 |
|
Less: Scrap value of old machine |
(1,20,000) |
(1,25,000) |
(90,000) |
(80,000) |
|
Add: increase in working capital |
30,000 |
30,000 |
30,000 |
30,000 |
|
±
Tax saving / paid on loss or gain on sale of old asset |
(1,500) |
0 |
(10,500) |
(13,500) |
|
Incremental initial cash outflow |
1,58,500 |
1,55,000 |
1,79,500 |
1,86,500 |
Capital loss = Book value of
asset – salvage/scrap value of asset
Capital Gain = Salvage/scrap value
of asset –Book value of asset
Depreciation on old machine = cost of old machine /
estimated life
= Rs. 1,75,000 / (5+2) = Rs. 25,000.
Book value of old machine today = Rs. 1,75,000 –
depreciation of 2 years of old machine
= Rs. 1,75,000 – Rs. 50,000 = Rs. 1,25,000
Calculation of tax
paid / saved
|
|
Case 1 Rs.1,20,000 |
Case 2 Rs.1,25,000 |
Case 3 Rs.90,000 |
Case 4 Rs.80,000 |
|
Book value of old machine |
1,25,000 |
1,25,000 |
1,25,000 |
1,25,000 |
|
Less : Scrap value of old machine |
(1,20,000) |
(1,25,000) |
(90,000) |
(80,000) |
|
Capital gain / loss |
5,000 loss |
0 |
35,000 loss |
45,000 loss |
|
Tax @ 30 % on Capital gain / loss |
1,500 |
0 |
10,500 |
13,500 |
|
Since, in Case I, III and IV, there is a capital loss. Hence, tax
calculated on capital loss is subtracted from initial cash outflow. |
||||
Calculation of
subsequent incremental annual cash inflow
|
|
Year 1 (Rs.) |
Year 2 (Rs.) |
Year 3 (Rs.) |
Year 4 (Rs.) |
Year 5 (Rs.) |
|
Cash inflow before depreciation and taxes from new machine |
70,000 |
90,000 |
1,00,000 |
90,000 |
1,00,000 |
|
Less: Cash inflow before depreciation and taxes from old machine |
(30,000) |
(30,000) |
(30,000) |
(30,000) |
(30,000) |
|
Incremental Cash inflow before depreciation and taxes |
40,000 |
60,000 |
70,000 |
60,000 |
70,000 |
|
Less: Incremental depreciation |
(25,000) |
(25,000) |
(25,000) |
(25,000) |
(25,000) |
|
EBT (Earning before tax) |
15,000 |
35,000 |
45,000 |
35,000 |
45,000 |
|
Less: Tax @ 30 % |
(4,500) |
(10,500) |
(13,500) |
(10,500) |
(13,500) |
|
PAT |
10,500 |
24,500 |
31,500 |
24,500 |
31,500 |
|
Add : incremental depreciation |
25,000 |
25,000 |
25,000 |
25,000 |
25,000 |
|
Incremental annual net cash inflow |
35,500 |
49,500 |
56,500 |
49,500 |
56,500 |
|
Terminal cash inflow (Release of working capital at the end of 5th
year) |
|
|
|
|
30,000 |
Calculation of
incremental Depreciation
Depreciation on new machine = cost of machine + installation
cost / estimated life
= Rs. 2,50,000 / 5 =
Rs. 50,000
Depreciation on old machine = cost of old machine /
estimated life
= Rs. 1,75,000 / (5+2) = Rs. 25,000
Incremental Depreciation = Depreciation on new machine -
Depreciation on old machine
= Rs. 50,000 – Rs. 25,000 = Rs. 25,000
Solution
Calculation of
subsequent annual cash inflow
|
Particulars |
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
|
Savings in annual operating cost |
70,000 |
70,000 |
70,000 |
70,000 |
70,000 |
|
Less: Tax @ 30 % |
(21,000) |
(21,000) |
(21,000) |
(21,000) |
(21,000) |
|
Net Saving |
49,000 |
49,000 |
49,000 |
49,000 |
49,000 |
|
Add: expenditure not required |
1,60,000 |
1,60,000 |
|||
|
Less: new expenditure required |
(2,00,000) |
(2,00,000) |
|||
|
Incremental tax saving |
12,000 |
12,000 |
2,400 |
14,400 |
4,800 |
|
Net Cash inflow |
(1,39,000) |
61,000 |
2,11,400 |
(1,36,600) |
2,13,800 |
Calculation of
Incremental tax saving
Incremental tax saving due to change in expenditure plan =
Tax saving on new expenditure – Tax saving on planned expenditure changed.
|
Particulars |
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
|
Depreciation on new expenditure |
40,000 |
40,000 |
40,000 |
80,000 |
80,000 |
|
Tax saving @ 30 % (A) |
12,000 |
12,000 |
12,000 |
24,000 |
24,000 |
|
Depreciation on planned expenditure |
0 |
0 |
32,000 |
32,000 |
64,000 |
|
Tax saving @ 30 % (B) |
0 |
0 |
9,600 |
9,600 |
19,200 |
|
Incremental tax saving (A-B) |
12,000 |
12,000 |
2,400 |
14,400 |
4,800 |
Depreciation on new expenditure incurred in year 1 = Rs.
2,00,000 / 5 = Rs. 40,000
Depreciation on new expenditure incurred in year 4 = Rs.
2,00,000 / 5 = Rs. 40,000
In 4th and 5th year Depreciation
amount will be Rs. 40,000 + Rs. 40,000 = Rs. 80,000 ( expenditure has been
incurred in year 1 and 4 ).
Depreciation on planned expenditure of year 3 = Rs. 1,60,000
/ 5 = Rs. 32,000
Depreciation on planned expenditure of year 5 = Rs. 1,60,000
/ 5 = Rs. 32,000
In 5th year Depreciation amount will be Rs.
32,000 + Rs. 32,000 = Rs. 64,000 (expenditure of year 3 and 5 both should be
considered.)
