To determine whether the company should go ahead with the plan for the acquisition of new machinery, we need to calculate the net present value (NPV) of the investment.
Step 1: Calculate the cash flows associated with the acquisition of new machinery:
- Initial investment: ₹30,000
- Salvage value at the end of year 5: ₹750,000
- Increase in annual profit before depreciation: ₹6,000
Step 2: Calculate the depreciation expense on the new machinery:
- Since the company uses the reducing balance method, we need to calculate the depreciation rate:
Depreciation rate = 1 - (Salvage value / Initial cost)^(1 / Useful life)
= 1 - (750,000 / 30,000)^(1 / 5)
Now, we need to calculate the annual depreciation expense using the reducing balance method:
Year 1: Depreciation expense = Initial cost * Depreciation rate
Year 2: Depreciation expense = (Initial cost - Year 1 depreciation expense) * Depreciation rate
...
Year 5: Depreciation expense = (Initial cost - Cumulative depreciation from Year 1 to Year 4) * Depreciation rate
Step 3: Calculate the tax shield benefits from depreciation:
- Tax shield benefit = Depreciation expense * Tax rate
- Tax rate on income: 55%
Step 4: Calculate the net increase in profits after-tax:
- Net increase in profit after-tax = Increase in annual profit before depreciation - Tax shield benefit
Step 5: Calculate the net cash flows for each year:
- Year 0: -Initial Investment
- Year 1-5: Net increase in profit after-tax + Depreciation expense
Step 6: Calculate the present value of net cash flows:
PV = Cash flow / Present value factor
Step 7: Calculate the NPV by summing the present value of net cash flows:
NPV = Sum of PV - Initial investment
Note: We also need to consider the cash flows related to the existing machinery.
Step 8: Calculate the net cash flows for the existing machinery:
- Salvage value of old machinery: ₹16,250
- Tax shield benefits for depreciation on old machinery
- Tax rate on capital gains: 40%
Step 9: Calculate the present value of net cash flows for the existing machinery:
- Year 0-3: Tax shield benefit + Salvage value + Depreciation expense
- Year 4: Tax shield benefit + Present value of tax shield benefits in Year 5
Step 10: Calculate the NPV of the existing machinery:
NPV = Sum of PV - Initial cost
Step 11: Compare the NPV of the new machinery with the NPV of the existing machinery:
- If the NPV of the new machinery is higher, then the company should go ahead with the acquisition.
- If the NPV of the existing machinery is higher, then it may be more beneficial to continue using the existing machinery.
Please provide the exact values for the tax shield benefits, tax rates, depreciation rates, and useful life of the old machinery (if not provided) to proceed with the calculations.