Mayur Textiles Ltd. engaged in manufacturing of yarns, decided to establish a new factory at Taloja, Maharastra.

It wants to replace its existing machine that generates revenue of Rs. 180.00 lacs with a new machine that will generate revenue of Rs. 337.50 lacs to the company. The existing machine was purchased 5 years ago. The net salvage value of the machine is Rs. 26.50 lacs. Current book value of the machine is Rs. 145.50 lacs and its realizable market value is Rs. 250.00 lacs. Depreciation of the machinery is on straight-line basis. Capital cost of new machinery is Rs. 950.00 lacs. Both the machines have remaining life of 7 years. The estimated net salvage value of the new machinery is Rs. 100.50 lacs. The companys sale will grow by Rs. 250.00 lacs annually. The operating expense will decline to the extent of Rs. 33.75 lacs. The new machine requires an additional inventory of Rs. 50 lacs and will cause an increase in accounts payable by Rs. 25.00 lacs. Corporate tax rate and cost of capital applicable are 25% and 11.5% respectively. You are required to advice whether Mayur Textiles Ltd. should replace the old machinery with new machinery.
Example: The Erickson Toy Corporation currently uses an injection-molding machine that was purchased 2 years ago. This machine is being depreciated on a straight-line basis toward a $500 salvage value, and it has 6 years of remaining life. Its current book value is $2,600, and it can be sold at $3,000 at this time. Thus, the annual depreciation expense is ($2,600-500)/6=$350 per year. The firm is offered a replacement machine that has a cost of $8,000, an estimated useful life of 6 years, and an estimated salvage value of $800. This machine falls into the MACRS 5-year class. The replacement machine would permit an output expansion, so sales would rise by $1,000 per year; even so, the new machines much greater efficiency would still cause operating expenses to decline by $1,500 per year. The new machine would require that inventories be increased by $2,000, but accounts payable would simultaneously increase by $500. The firms marginal federal-plus-state tax rate is 40%, and its cost of capital is 15%. Should it replace the old machine?

(a) Initial investment The firm pays Rs 950.00 lacs for the new machine (capital cost) but this is offset by the Rs 250.00 lacs received from the sale of the old machine (Realizable market value). The firm has to be very careful when dealing with the tax on the sale of the old machine. Since the old machine still has a book value of Rs 145.50 lacs, the firm made a profit of Rs 104.50 lacs by selling it at Rs 250.00 lacs. Hence, the tax on the old machine is Rs 26.125 lacs (ie 104.50 * 0.25). In addition, the firm also needs to worry about the change in net working capital resulted from the new machine. Keep in mind that a firm's net working capital is defined as current asset current liability . We know the inventory of Rs 50 lacs represents a current asset for the firm, but the account payable of Rs 25 lacs represents a current liability. Hence the change in the firm's NWC is Rs 50 Rs 25= Rs 25 lacs.
Year 0 -Rs 950.00 250.00 -26.125 -25.00 -Rs 751.125

Cost of new machine Sale of old machine Tax on old machine Change in NWC Total cash flow

(b) Depreciation recovery of computer Determining the depreciation recovery of the new machine is a little bit tricky because we need to take into consideration of opportunity cost of lost depreciation from the old machine.
Year 1 2 3 4 5 6 7 8 New Rs 133 237.50 161.50 123.50 85.50 85.50 85.50 38.00 Old Rs17.00 17.00 17.00 17.00 17.00 17.00 17.00 17.00 Recovery Rs 116.00 220.50 144.50 106.50 68.50 68.50 68.50 21.00 Tax shield Rs 29.00 55.125 36.125 26.625 17.125 17.125 17.125 5.25

(c) Annual after-tax operating cash flow

Year 1 After-tax revenue and savings on expenses Depreciation tax shield After-tax cash flow 33.75 29.00 62.75 Year 2 33.75 55.125 88.875 Year 3 33.75 36.125 69.875 Year 4 33.75 26.625 60.375 Year 5 33.75 17.125 50.875 Year 6 33.75 17.125 50.875 Year 7 33.75 17.125 50.875 Year 8 33.75 5.25 39.00

(d) Terminal cash flow

Year 8 Rs 100.50 - 25.125 -500 1,500 $1,480

Salvage value of new machine Tax on salvage value Opportunity cost of old machine Recapture of NWC Total terminal cash flow

(e) Annual after-tax cash flows for the project

Year 0 1 2 3 4 5 6 Amount -$6,660 2,000 2,384 1,968 1,744 1,712 3,032

Using a financial calculator, we know when the cost of capital is 15% the NPV of this project is $1,334.89. As a result, the firm should replace the old machine.