Question

XYz Itd is considering the possibitity of manufacturing a particular component which at present is being bought from outside. The manufacture of the component would call for an investment of 77,50,000 in a new machine besides an additional investment of ₹50,000 in working Capital, The life of the machine would be 10 Years, with a salvage value of 250,000 . The estimated savings (belore tax) would be ₹ 1,80,000 per annum. The income tax rate is 50%. The company's required rate of return is 10%. Depreciation is provided on straight line basis. Suggest the firm whether this investment to be made or not. Show your detailed workings.

Answer 1

XYz Itd should calculate the net present value (NPV) of the investment into manufacturing a component by considering the tax-affected savings, depreciation benefits, and the salvage value, discounted at the firm's required rate of return. A positive NPV would warrant proceeding with the investment, while a negative NPV would suggest otherwise.

The decision on whether XYz Itd should invest in the manufacturing of a component involves calculating the net present value (NPV) of the investment considering the cost savings, depreciation, tax implications, and the company's required rate of return. The initial investment includes the cost of the new machine (₹77,50,000) and additional working capital (₹50,000). The machine has a salvage value of ₹250,000 after 10 years and will provide annual savings of ₹1,80,000 before tax. To calculate the NPV, we must subtract tax from the annual savings, add the salvage value, and subtract the initial investments, all while discounting future cash flows back to their present value at the required rate of return (10%). Depreciation is computed using the straight-line method.

The annual depreciation is (Cost of the machine - Salvage value) / Life of the machine = (77,50,000 - 250,000) / 10 = ₹7,25,000 per annum. The tax saving due to depreciation is annual depreciation * tax rate = ₹7,25,000 * 50% = ₹3,62,500 per annum. The net annual savings after tax is (Annual savings - Tax on savings) + Tax saving due to depreciation = (₹1,80,000 - ₹90,000) + ₹3,62,500 = ₹4,52,500. The NPV of the investment can be calculated by discounting the annual net savings and the salvage value minus the initial investment at the firm's required rate of return of 10%.

The NPV is positive if the discounted cash flows exceed the initial investments. If the NPV is positive, it suggests that the investment will generate a return above the company's required rate of return, and thus XYz Itd should proceed with the investment. If the NPV is negative, the firm should not invest in the manufacturing of the component as it would not meet the required rate of return.