Problems on Specific Management Decision

Owning or Leasing Asset:

1. A company proposes to acquire a plant and machine on 1-04-2021for its business. It would cost about Rs. 150,000. It is
expected to have a working life of 3 years and estimated scrap value is of Rs. 40,000. The plant and machine can be
purchased through borrowed funds. Rate of interest is 15% p.a. the loan is repayable in 3 annual equal installments of Rs.
50,000 each.

The machine can be acquired through lease. Lease rent is Rs. 60,000. Profit before depreciation and tax is expected to be
1,00,000 every year and rate of depreciatio
n is 15% (ignore add depreciation). The present value of annuity of Re.1 at the rate of 10%. Advise X ltd whether machinery
can be acquired from own funds, borrowed funds and lease rentals.
solution
Case 1: Own Funds
Computation of Cash Inflow ( Tax Shield depreciation + Present value of Scrap Value)

Tax Shield 30%

Year Depreciation +4% PV @10% Present Value
1 22,500 7,020 0.909 6,381
2 19,125 5,967 0.826 4,929
3 16,256 5,072 0.751 3,810
3 (Scrap Value) 40,000 - 0.751 30,040
TOTAL 45,160
Pv = 1/ (1+ 0.1) = 0.909
Pv = 0.909/ (1+ 0.1) = 0.826
Depreciation Calculation:
1st Year: 1,50,000*15% = 22,500
2nd Year: (1,50,000-22,500) 1,27,500*15% = 19125
3rd Year: (1,27,500-19125) 1,08,375*15% =16,256

NET CASH OUTFLOW= TOTAL CASH OUT FLOW - TOTAL CASH INFLOW
1,50,000-45160 = 1,04,840

Case 2: Borrowed Funds

Computation of Cash Outflow
Year Repayable Interest Total cash outflow PV @10% Present Value
1 50,000 22,500 72,500 0.909 65,903
2 50,000 15,000 65,000 0.826 53,690
3 50,000 7,500 57,500 0.751 43,183
TOTAL 1,62,776

Computation of Cash Inflow ( Tax Shield depreciation + Present value of Scrap Value)
(Depreciation+Inter
Year Depreciation Interest est) Tax Pv @10% Present Value
1 22,500 22,500 45,000 14,040 0.909 12,762
2 19,125 15,000 34,125 10,647 0.826 8,794
3 16,256 7,500 23,756 7,412 0.751 5,566
3 (SV) 40,000 - - - 0.751 30,040
TOTAL 57,162
 Depreciation Calculation:
1st Year: 1,50,000*15% = 22,500
2nd Year: (1,50,000-22,500) 1,27,500*15% = 19125
3rd Year: (1,27,500-19125) 1,08,375*15% = 16,256

Interest Calculation:
1st Year: 1,50,000*15% = 22,500
2nd Year: (1,50,000- 50,000) *15% = 15,000
3rd Year: (1,00,000 - 50,000) 50,000*15% = 7,500
NET CASH OUTFLOW= TOTAL CASH OUT FLOW - TOTAL CASH INFLOW
1,62,776 - 57162 = 1,05,614

Case 3: Lease Rentals

Present value ( Cash Present value of
Year Cash Flow Tax Pv @10% Flow) (Tax)
1 60,000 18,720 0.909 54,540 17,016
2 60,000 18,720 0.825 49,500 15,444
3 60,000 18,720 0.751 45,060 14,059
TOTAL 1,49,100 46,519
Net Cash Out Flow: 1,49,100 - 46,519 = 1,02,581

Conclusion: It is recommended that company should acquire capital asset through lease rentals which is causing less
expenditure than other 2 alternatives

2. An asset costing Rs. 1,00,000 is acquired. Two alternatives are available

Buy asset by taking loan of Rs. 1,00,000 repayable in five equal installment of Rs. 20,000 each along with interest at 14%
per annum.
Leasing the asset for which lease rent is Rs. 30,000 upto 5 years charge of 1% processing fee in the first year assume cost on
capital (PV rate) 10% and tax rate to be 30%+4% cess (31.2%). Depreciation at 15%. Ignore additional depreciation.
Suggest which alternative is better in above case.

solution
Case 1: Borrowed Funds
Computation of Cash Outflow
Year Repayable Interest Total cash outflow PV @10% Present Value
1 20,000 14,000 34,000 0.909 30,906
2 20,000 11,200 31,200 0.826 25,771
3 20,000 8,400 28,400 0.751 21,328
4 20,000 5,600 25,600 0.683 17,485
5 20,000 2,800 22,800 0.621 14,159
TOTAL 1,09,649
Computation of Cash Inflow ( Tax Shield depreciation + Present value of Scrap Value)
(Depreciation+Interest
Year Depreciation Interest ) Tax Pv @10% Present Value
1 15,000 14,000 29,000 9,048 0.909 8,225
2 12,750 11,200 23,950 7,472 0.826 6,172
3 10,838 8,400 19,238 6,002 0.751 4,508
4 9,212 5,600 14,812 4,621 0.683 3,156
5 7,830 2,800 10,630 3,317 0.621 2,060
TOTAL 24,121
Depreciation Calculation:
 1st Year: 1,00,000*15% = 15,000
2nd Year: (1,00,000-15,000) 85,000*15% = 12,750
3rd Year: (85,000-12750) 72,250*15% = 10,838
4th Year: (72,250-10,838) 61,412*15% = 9,212
5th Year: (61,412-9,212) 52,200*15% = 7,830

Interest Calculation:
1st Year: 1,00,000*14% = 14,000
2nd Year: (1,00,000- 20,000) 80,00*14% = 11,200
3rd Year: (80,000 - 20,000) 60,000*14% = 8,400
4th Year: (60,000 - 20,000) 40,000*14% = 5,600
5th Year: (40,000 - 20,000) 20,000*14% = 2,800

NET CASH OUTFLOW= TOTAL CASH OUT FLOW - TOTAL CASH INFLOW
1,09,649 - 24,121 = 85,528
Case 2: Lease Rentals
Present
Present value value of
Year Cash Flow Tax Pv @10% ( Cash Flow) (Tax)
1 31,000 9,672 0.909 28,179 8,792
2 30,000 9,360 0.826 24,780 7,731
3 30,000 9,360 0.751 22,530 7,029
4 30,000 9,360 0.683 20,490 6,393
5 30,000 9,360 0.621 18,630 5,813
TOTAL 1,14,609 35,758
Processing Charge for lease rent in 1st year : 1,00,000*1% = 1,000

Net Cash Out Flow: 1,14,609 - 35,758 = 78,851

Conclusion: It is recommended that company should acquire capital asset through lease rentals which is causing less
expenditure than borrowed capital

3. The ABC Ltd., is in tax bracket of 35%. In the acquisition of an asset worth Rs 10,00,000; it’s given two offers: either to
acquire the asset by taking a bank loan @15% p.a. repayable in 5 yearly installments of Rs. 200,000. Each plus interest or to
lease in the asset at an yearly rentals of Rs. 3,24,000 for 5 years. In both the cases, the installments is payable at the end of the
year. Applicable rate of depreciation is 15% using WDV method.
You are required to suggest the better alternative:
Years 1 2 3 4 5
PV factor 0.862 0.743 0.641 0.552 0.476

solution
Case 1: Borrowed Funds

Computation of Cash Outflow

 Total cash
Year Repayable Interest outflow PV Factor Present Value
1 2,00,000 1,50,000 3,50,000 0.826 3,01,700
2 2,00,000 1,20,000 3,20,000 0.743 2,37,760
3 2,00,000 90,000 2,90,00 0.641 1,85,890
4 2,00,000 60,000 2,60,000 0.552 1,43,520
5 2,00,000 30,000 2,30,000 0.476 1,09,480
TOTAL 9,78,350

Computation of Cash Inflow ( Tax Shield depreciation + Present value of Scrap Value)
(Depreciation+Int PV
Year Depreciation Interest erest) Tax@ 35% Factor Present Value
1 1,50,000 1,50,000 3,00,000 1,05,000 0.826 86,730
2 1,27,500 1,20,000 2,47,500 86,625 0.743 64,362
3 1,08,375 90,000 1,98,375 69,431 0.641 44,505
4 92,119 60,000 1,52,119 53,242 0.552 29,390
5 78,301 30,000 1,08,301 37,905 0.476 18,043
TOTAL 2,43,030
Depreciation
Calculation:
1st Year: 10,00,000*15% = 1,50,000
2nd Year: (10,00,000-1,50,000) 8,50,000*15% = 1,27,500
3rd Year: (8,50,000-1,27,500) 7,22,500*15% = 1,08,375
4th Year: (7,22,500-1,08,375) 6,14,125*15% = 92,119
5th Year: (6,14,125-92,119) 5,22006*15% = 78,301

Interest Calculation:
1st Year: 10,00,000*15% = 1,50,000
2nd Year: (10,00,000- 2,00,000) 8,00,00*15% = 1,20,000
3rd Year: (8,00,000 - 2,00,000) 6,00,000*15% = 90,000
4th Year: (6,00,000 - 2,00,000) 4,00,000*15% = 60,000
5th Year: (4,00,000 - 2,00,000) 2,00,000*15% = 30,000

NET CASH OUTFLOW= TOTAL CASH OUT FLOW - TOTAL CASH INFLOW
9,78,350 - 2,43,030 = 7,29,320

Case 2: Lease Rentals

Present value of
Year Cash Flow Tax Pv Factor Pv ( Cash Flow) (Tax)
1 3,24,000 1,13,400 0.826 2,67,624 93,668
2 3,24,000 1,13,400 0.743 2,40,732 84,257
3 3,24,000 1,13,400 0.641 2,07,684 72,690
4 3,24,000 1,13,400 0.552 1,78,848 62,597
5 3,24,000 1,13,400 0.476 1,54,224 53,978
TOTAL 10,49,112 3,67,190
 Net Cash Out Flow: 10,49,112 - 3,67,190 = 6,81,922

Conclusion: It is recommended that company should acquire capital asset through lease rentals which is causing less
expenditure than borrowed capital

Repair or Replacement of an Asset:

1. A company is considering to repair or replace a particular machine which has just broken down. Last year this machine
costed Rs. 20,000 to run and maintain, this cost has increased in real terms in recent year with age to machine. A future
useful life of 5 years is expected if immediate repair of Rs. 19,000 are incurred. If machine is not repaired it shall be sold
immediately which realizes Rs. 5,000 (ignore gain or loss on such disposal).

Alternatively a company can buy new machine of Rs. 49,000 with an expected life of 10 years without any salvage value
after providing for depreciation under straight line method. In this case, the running and maintenance expense will reduce to
Rs. 14,000 each year and are not expected to increase much in real terms for few years at least.
Assume tax rate @ 31.2%, COC @10%. Suggest the company either to repair or replace above asset.
Solution
Case 1: Repair Decision
Computation of Cash Outflow
Particulars Amount
Cashflow (Immediate) 19,000

Repair & Maintenance Cost

(20,000*Pv@10% for 5 Years) 75,800
Total Cash Outflow 94,800

1 2 3 4 5 Total
0.909 0.826 0.751 0.683 0.621 3.79

Computation of Tax shield on Repair Expenses

Particulars Amount
Cash for repair (19,000* 31.2%) 5,928

Repair & Maintenance Cost

(20,000*31.2%*3.79) 23,650
Total Cash Inflow 29,578
Net Cash Flow: 94,800 - 29,578 = 65,222
Case 2: Replace Decision
Computation of Cash Outflow
Particulars Amount
Cost of Machine (49000-5000) 44,000

Repair & Maintenance Cost

(14,000*Pv@10% for 10 Years) 85,988
Total Cash Outflow 1,29,988

Year 1 2 3 4 5 6 7 8 9 10

PV 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.466 0.424 0.385
 Computation of Tax shield on Replace asset
Depreciation Calculation: (49,000-0)/10 = 4,900
Particulars Amount
Depreciation (4,900* 31.2%*6.142) 9,390

Repair & Maintenance Cost

(14,000*31.2%*6.142) 26,828
Total Cash Inflow 36,218
Net Cash Flow: 1,29,988 - 36,218 = 93,770

Conclusion: It is recommended that company should go for repair of machine as Net

Cash Flow greater in replacement of machine.
Continue or Suspension of Business Activity:

1. A company is a domestic company has two businesses A & B. For the last 2 years business A has been running at loss
wiping out the entire profit of business B. At the end of financial year 2020-2021 there are brought forward loss of Rs.
8,00,000 and Unabsorbed depreciation of Rs. 5,00,000.
In the financial year 2021-2022 onwards, it is expected that business B will earn profit of Rs. 5,00,000 and if business A is
continued at a minimum level, there will be an annual loss of Rs. 1,00,000. Assume a tax rate of 31.2%.
Suggest the management: Whether business A should be continued or shut down? If, continued, for how many years?
Solution
Case 1: Continue Business Activity
If Business "A" is continued
Particulars 1 2 3 4
Profits from business "B" 5,00,000 5,00,000 5,00,000 5,00,000
(-) Loss from business "A" 1,00,000 1,00,000 1,00,000 1,00,000
Total 4,00,000 4,00,000 4,00,000 4,00,000
(-) Brought forword Business Loss 4,00,000 4,00,000
(-) Brought forword Unabsorbed Depreciation 4,00,000 1,00,000
Profits Before Tax - - - 3,00,000
(-) Tax @31.2% - - - 93,600
Profits After Tax - - - 2.06,400

Cash Flow (Profits after tax + Non Cash

Expenses) 4,00,000 4,00,000 4,00,000 3,06,400

Case 2: Suspended Business Activity

If Business "A" is Suspended
Particulars 1 2 3 4
Profits from business "B" 5,00,000 5,00,000 5,00,000 5,00,000
 (-) Brought forword Business Loss 5,00,000 3,00,000
(-) Brought forword Unabsorbed Depreciation 2,00,000 3,00,000 -
Profits Before Tax - - 2,00,000 5,00,000
(-) Tax @31.2% - - 62,400 1,56,000
Profits After Tax - - 1,37,600 3,44,000

Cash Flow (Profits after tax + Non Cash Expenses) 5,00,000 5,00,000 4,37,600 3,44,000

Conclusion: Suspend the business activity of "A" and continue with business "B".

Make or Buy:
1. A company produces most of its own components for that it spends the following:
Standard wages rate Rs. 12/hour; Variable manufacturing overheads Rs. 9/hour; Fixed manufacturing overheads Rs.
10.50/hour
A company can require a new part which can be made at its own department without any expenses that it will increases cost
of product. Product testing by Rs. 15,000/month. Estimated labor time for a new part in half an hour/unit. Raw materials
cost is Rs.24/unit.
The company has alternative choice to purchase this part from outside for Rs.36/unit. The company is estimated to produce
2,00,000 new parts for its requirement advice the company to make or buy the components?
Solution
Output: 2,00,000 Units

Particulars Cost per unit Total Cost

Raw material cost 24 48,00,000

Direct Labor
1 hour - Rs. 12
1/2 hour - Rs. ? 6 12,00,000

Direct Expenses
Variable overheads
1 hour - Rs. 9
1/2 hour - Rs.? 4.5 9,00,000
Marginal Cost 34.5 69,00,000

Product Testing (Rs. 15,000*12 months)

(1,80,000/2,00,000 Uints) 0.9 1,80,000
Cost of Manufacturing 35.4 70,80,000

Conclusion: It is advisible to make the component as it works out to be cheaper than buying it from outside. It can save
0.6*2,00,000 = 1,20,000 p.a.