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Sample of Finance Homework Illustrations and Solutions:
Question 1: ABC and Co. is considering a proposal to replace one of its plants costing $ 60,000
and having a written down value of $ 24,000. The remaining economic life of the plant is 4 years
after which it will have no salvage value. However, if sold today, it has a salvage value of $
20,000 The new machine costing $ 1,30,000 is also expected to have a life of 4 years with a
scrap value of $ 18,000 The new machine, due to its technological superiority, is expected to
contribute adapted with decision given that the tax rate applicable to the firm is 40%. (The
capital gain or loss may be taken as not subject to tax.)
Solution:
1. Initial cash outflow
Cost of new machine
-Scrap value of old machine
$ 1,30,000
20,000
1,10,000
2. Subsequent cash inflows (annual)
Incremental benefit
-Incremental Depreciation
Dep. on new machine
Dep. on old machine
Profit before tax
$ 60,000
$ 28,000
22,000
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15,200
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-Tax @ 40%
Profit after tax
Depreciation (added back)
22,800
22,000
44,800
Annual cash inflow
The amount of depreciation of $ 28,000 on the new machine is ascertained as follows ($
1,30,000 - $18,000)/4 = $ 28,000. It may be noted that in the given situation, the benefits are
given in the incremental from i.e., the additional benefits contributed by the proposal. Therefore,
only the incremental depreciation of $ 22,000 has been deducted to find out the taxable profits.
The same amount of depreciation has been added back to find out the incremental annual cash
inflows.
3. Terminal Cash inflow : There will be an additional cash inflow of $ 18,000 at the end of 4 th
year when the new machine will be scrapped away. Therefore, total inflow of the last year would
be $ 62,800 (i.e., $ 44,800 + $ 18,000)
Question 2:
XYZ is interested in assessing the cash flows associated with the replacement of an old machine
by a new machine. The old machine bought a few years ago has a book value of $ 90,000 and it
can be sold for $ 90,000. It has a remaining life of five years after which is salvage value is
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expected to be nil. It is being depreciated annually at the rate of 20 percent (written down value
method.)
The machine costs $ 4,00,000 it is expected to fetch $ 2,50,000 after five years when it will no
longer be required. It will be depreciated annually at the rate of 33 1/3 percent (written down
value method). The new machine is expected to bring a saving of $ 1,00,000 in manufacturing
costs. Investment in working capital would remain unaffected. The tax rate applicable to the
firms is 50 percent.
Find out the relevant cash flows for this replacement decision.
Solution:
Initial cash flow :
Cost of new machine
$ 4,00,000
-Salvage value of old machine
90,000
3,10,000
Subsequent annual cash flows:
(Amount $ ‘000)
Yr.1
Yr.2
Yr.3
Yr.4
Yr.5
100
100
100
100
100
Depreciation on new machine
133.3 88.9
59.3
39.5
263
-Depreciation on old machine
18.0
11.5
9.2
7.4
Savings in costs (A)
14.4
Therefore, incremental depreciation (B)
115.3 74.5
47.8
30.3
18.9
Net incremental savings (A- B)
-15.3 25.5
52.2
69.7
81.1
Less : Incremental Tax @ 50%
-7.6
12.8
26.1
34.8
40.6
Incremental Profit
-7.7
12.7
26.1
34.9
40.5
Depreciation (added back)
115.3 74.5
47.8
30.3
18.9.
Net cash flow
107.6 87.2
73.9
65.2
59.4
Terminal cash flow : There will be a cash inflow of $ 2,50,000 at the end of 5th year when the
new machine will be scrapped away. So, in the last year the total cash inflow will be $ 3,09,400
(i.e., $ 2,50,000 + $ 59,400)
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Question 3: XYZ Ltd. Is trying to decide whether it should replace a manually operated
machine with a fully automatic version of the same machine. The existing machine, purchased
ten years ago, has a book value of $ 40,000 and remaining life of 10 years. Salvage value was $
40,000. The machine has recently begun causing problems with breakdowns and is costing the
company $ 20,000 per year in maintenance expenses. The company has been offered $ 1,00,000
for the old machine as a trade-in on the automatic model which has been offered $ 1,00,000 for
the old machine as a trade-in on the automatic model which has a deliver price (before allowance
for trade-in) of $ 2.20,000. It is expected to have a ten-year life and a salvage value of $ 20,000.
The new machine will require installation modifications costing $ 40,000 to the existing
facilities, but it is estimated to have a cost savings in materials of $ 80,000 per year. Maintenance
costs are included in the purchase contract and are borne by the manufacturer. The tax rate is
40% (applicable to both revenue income as well as capital gains/losses). Straight line
depreciation over ten years will be used. Find out the relevant cash flows.
Solution:
Initial cash outflow:
Cost of new machine
$ 2,20,000
+ Initial expenses
40,000
2,60,000
Trade-in
1,00,000
1,60,000
-Tax savings (40% of $ 2,40,000 – 1,00,000)
56,000
$ 1,04,000
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Subsequent cash flows :
Cost reduction (savings)
80,000
+Repairs (not required)
20,000
Depreciation on new machine
1,00,000
24,000
(2,20,000 + 40,000 – 20,000)/10
Depreciation on old machine
10,000
(2,40,000 – 40,000)/10
Therefore, incremental dep.
4,000
Net savings
96,000
Tax@40%
34,000
Savings after tax
51,600
Depreciation (added back)
14,000
Annual cash inflow
65,600
Terminal cash flow : There will be a cash inflow of $ 20,000 at the end of 10th year when the
new machine will be scrapped away. So, in the last year the total cash inflow will be $ 85,600
(i.e., $ 20,000 + $ 65,600)
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Question 4: Chandra Ltd. purchased a special machine one year ago at a cost of $ 12,000. At
that time the machine was estimated to have a useful of 6 years and no salvage value. The annual
cash operating cost is approximately $ 20,000. A new machine has just come on the market
which will do the same job but with an annual cash operating cost of only $ 17,000. The new
machine costs 21,000 and has an estimated life of 5 years with zero salvage value. The old
machine can be sold for $ 10,000 to a scrap dealer. Straight line depreciation is used, and the
company’s income tax rate is 40 percent. Assuming a cost of capital of 8% you are required to
compute the incremental cash flows after taxes.
Solution:
Calculation of Incremental Cash flows:
Initial Outflow:
Cost of New machine
$ 21,000
-Sale Value of Old machine
$ 10,000
11,000
Subsequent Annual Inflows:
Cash Operating Cost of Old machine
$ 20,000
-Cash Operating Cost of New machine
$ 17,000
Savings in Cash Operating Cost
$ 3,000
Depreciation of old machine (1200 ÷ 6)
$ 2,000
$ 3,000
Depreciation on New machine (21,000 ÷ 5) 4,200
Increase in Depreciation
$ 2,200
Net increase in Profit before Tax
Tax @40%
800
Incremental Cash flow :
320
Savings in Cash Operating Cost
$ 3,000
-Increase in Tax Liability
320
Net Cash Inflow
2680
Terminal Inflow
Nil
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