Worked Solution
✓ VerifiedNet Present Value (NPV) Analysis — Machine Replacement Decision
Step 1: Net Initial Investment (Cash Outflow at Year 0)
The existing machine was purchased 5 years ago for ₹16,00,000 with a total useful life of 5 years. Under the Straight-Line Method (SLM), it is now fully depreciated; its book value = ₹0.
Sale proceeds from old machine = ₹9,60,000. Since book value is ₹0, the entire ₹9,60,000 is a taxable capital gain.
Tax on gain = 35% × ₹9,60,000 = ₹3,36,000
Net realisation from old machine = ₹9,60,000 − ₹3,36,000 = ₹6,24,000
Net Initial Investment = Cost of new machine − Net realisation
= ₹32,00,000 − ₹6,24,000 = ₹25,76,000
Step 2: Incremental Annual Operating Cash Flows (Years 1–5)
Depreciation on new machine (SLM) = (₹32,00,000 − ₹3,20,000) ÷ 5 = ₹28,80,000 ÷ 5 = ₹5,76,000 p.a.
Depreciation on old machine = ₹0 (fully depreciated)
Incremental depreciation = ₹5,76,000
Incremental contribution margin = ₹18,40,000 − ₹16,00,000 = ₹2,40,000
Annual operating savings = ₹3,20,000
Total incremental pre-tax benefit (before depreciation) = ₹5,60,000
Incremental taxable income = ₹5,60,000 − ₹5,76,000 = −₹16,000 (loss → tax shield)
Tax effect = 35% × (−₹16,000) = −₹5,600 (saving)
Incremental PAT = −₹16,000 + ₹5,600 = −₹10,400
Annual incremental Operating Cash Flow (OCF) = PAT + Depreciation
= −₹10,400 + ₹5,76,000 = ₹5,65,600
Step 3: Terminal Cash Flow (Year 5)
Salvage value of new machine = ₹3,20,000 = book value at end of year 5 (no capital gain/loss)
Terminal cash flow = ₹3,20,000
Step 4: NPV Calculation
NPV = −Initial Investment + (Annual OCF × PVIFA₁₂%,₅) + (Terminal Value × PVF₁₂%,₅)
= −₹25,76,000 + (₹5,65,600 × 3.605) + (₹3,20,000 × 0.567)
= −₹25,76,000 + ₹20,38,988 + ₹1,81,440
= −₹3,55,572
Conclusion: The NPV of replacing the machine is negative (−₹3,55,572). Based on NPV criterion, Global Beverage Corporation should not replace the existing molding machine, as the investment destroys value at the 12% cost of capital.
Write it like this
1The skeleton
- Lead with Net Initial Investment — write this as a labeled heading before any number, because examiners award 1 mark just for correctly structuring the Year-0 outflow block; don't bury it mid-para.
- Flag the zero book value explicitly — state 'old machine is fully depreciated (5 years life, 5 years old), so BV = ₹0' before computing tax on sale proceeds; this one line justifies why the entire ₹9,60,000 is taxable and saves you from a carry-forward error.
- Build Incremental OCF as a mini P&L — show Incremental Contribution + Savings → minus Incremental Depreciation → Taxable Income → Tax → PAT → add back Depreciation → OCF; this step-by-step layout earns partial marks even if your final number is off.
- Call out the tax shield on the loss — when incremental taxable income is negative (−₹16,000 here), explicitly write 'tax saving = 35% × loss' so the examiner sees you understand the shield, not just copy-pasted a formula.
- NPV line must show the formula then substitute — write NPV = −Initial Investment + (OCF × PVIFA) + (TV × PVF) first, then plug numbers; skipping the formula and going straight to arithmetic drops a presentation mark.
- Close with a one-line decision — 'Since NPV is negative, the replacement should not be undertaken' signals you know what NPV means and picks up the conclusion mark with zero extra effort.
2Examiner-rewarded phrases
3Common trap
Almost everyone forgets to tax the sale proceeds of the old machine — they subtract ₹9,60,000 directly from ₹32,00,000 without checking book value first. The moment you see a machine at the end of its useful life, your first move should be 'BV = 0, so the full sale price is a capital gain'; missing this cascades into a wrong initial investment and kills 2–3 marks downstream.