In order to reduce operating costs, a multi-product firm proposes to convert a manual operation in one of its plant into an automated one by incurring initial expenditure of Rs.1,00,000 in buying and installing. The automated device having an estimated life of 5 years with a scrap value at the end. The device is expected to reduce the operating expenses by Rs.36,000 per annum. The equipment will require an extensive overhauling at the end of second year and fourth year, the cost of involve being Rs.5,000 each time. In addition annual repairs and maintenance cost of Rs.1,000. The equipment is entitled to depreciate for tax purpose over a period of 3 years in equal installments. Marginal tax rate is 40% and Cost of Capital is 20%. Should the proposal be accepted?
We will find the difference of Present values of Net Inflow and Net Outflow and if the difference is positive then we'll go with the proposal. The Present Value of Cash Inflow = Savings on Operating Profits + Tax Savings on Overhauling + Tax Savings on Repair + Tax Savings on Depreciation = 139298.10 Since, Savings on Operating Profits \(=36000\require{enclose}a_{\enclose{actuarial}{5}}{@20\%}=107662.04\) Tax Savings on Overhauling \(=(50000\times40\%)(v_{@20\%}^2+v_{@20\%}^4)=2353.40\) Tax Savings on Repair\((1000\times40\%)\) \(=400\require{enclose}a_{\enclose{actuarial}{5}}{@20\%}=1196.24\) Tax Savings on Depreciation\((33333.33\times40\%)\) \(13333.33\require{enclose}a_{\enclose{actuarial}{3}}{@20\%}=28086.42\) Again the Present Value of Cash Outflow = Initial Outlay + Overhauling + Repair = 108874.10 Since, Initial Outlay = 100000 Overhauling \(=5000(v_{@20\%}^2+v_{@20\%}^4)=5883.49\) Repair \(=1000\require{enclose}a_{\enclose{actuarial}{5}}{@20\%}=2990.61\) Therefore, Present Value of Cash Inflow - Present Value of Cash Outflow =30424 We would go with the project. My question is whether I have treated the Depreciation in right way. I am not sure of this treatment of Depreciation.
as far as accountancy is concerned, overhauling is considered a capital charge and hence depreciation must be charged on that. no such need for repairs
Does that mean the treatment of depreciation on repairs to be excluded and only capital expenditures to be considered for the depreciation?
