Company Y is operating an elderly machine that is expected to produce a net cash inflow of Rs. 40,000 in the coming year and Rs. 40,000 next year. Current salvage value is Rs. 80,000 and next year’s value is Rs. 70,000. The machine can be replaced now with a new machine, which costs Rs. 1,50,000, but is much more efficient and will provide a cash inflow of Rs. 80,000 a year for 3 years. Company Y wants to know whether it should replace the equipment now or wait a year with the clear understanding that the new machine is the best of the available alternatives and that it in turn be replaced at the optimal point. Ignore tax. Take opportunity cost of capital as 10 percent. Advise with reasons.
Statement showing Present Value of Cash inflow of New Machine when it replaces Elderly Machine Now
Cash inflow of a new machine per year Rs. 80,000
Cumulative present value for 1-3 years @ Rs. 10% 2.486
Present value of cash inflow for 3 years (Rs. 80,000 2,486)Rs. 1,98,880
Less: Cash Outflow
Purchase cost of new machine 1,50,000
Less: Salvage value of old machine 80,000 70,000
N.P.V of cash inflow for 3 years 1,28,880
Equivalent annual net present value of cash
inflow of new machine (128880/2486) 51,842
Statement showing Present Value of Cash inflow of New machine when it replaces Elderly Machine Next Year
Cash inflow of new machine per year Rs. 80,000
Cumulative present value of 1-3 years @10% 2.486
Present value of cash inflow for 3 years (Rs. 80,000 * 2.486) 1,98,880
Less: Cash outflow
Purchase cost of new machine 1,50,000
Less: Salvage value of old machine 70,000 80,000
N.P.V. of cash inflow for 3 years 1,18,880
Advise: Since the equivalent annual cash inflow of new machine now and next year is more than cash inflow (Rs. 40,000) of an elderly machine the company Y is advised to replace the elderly machine now. Company Y need not wait for the next year to replace the elderly machine since the equivalent annual cash inflow now is more than the next year’s cash inflow
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