(a) Six years ago, a machine was purchased for ₹ 3,00,000. It has been depreciated to a book value of ₹ 1,80,000. Its economic…

(a) Evaluation of Replacement Decision

To evaluate the replacement proposal, incremental cash flows are computed over the 8-year economic life of the new machine at a 10% discount rate. Although the question mentions savings for 10 years, only 8 years can be counted, because the new machine producing them lasts 8 years and PV factors are given only up to year 8. The loss on sale of the old machine is assumed to give an immediate tax saving, as in the usual textbook treatment.

The initial cash outlay involves the acquisition cost of the new machine of ₹4,50,000 less the salvage value of the old machine of ₹10,000 and the tax shield arising from the loss on sale of the old machine. The book value of the old machine is ₹1,80,000, yielding a capital loss of ₹1,70,000 (₹1,80,000 − ₹10,000). At a 55% tax rate, this generates a tax saving of ₹93,500 (₹1,70,000 × 0.55). Thus, Net Initial Outlay = ₹4,50,000 − ₹10,000 − ₹93,500 = ₹3,46,500.

Annual depreciation on the old machine is ₹20,000 (₹3,00,000 / 15 years), while annual straight-line depreciation for the new machine is ₹50,000 [(₹4,50,000 − ₹50,000) / 8 years], generating an incremental depreciation of ₹30,000. Annual Incremental Operating Cash Flow After Tax (CFAT for Years 1–8) is calculated as: CFAT = Δ Operating Savings × (1 - t) + Δ Depreciation × t CFAT = (₹60,000 × 0.45) + (₹30,000 × 0.55) = ₹27,000 + ₹16,500 = ₹43,500 per annum.

Cumulative PV factor (Years 1–8 at 10%) = 0.909 + 0.826 + 0.751 + 0.683 + 0.621 + 0.564 + 0.513 + 0.467 = 5.334. Present value of operating cash inflows = ₹43,500 × 5.334 = ₹2,32,029. Present value of terminal salvage value at Year 8 = ₹50,000 × 0.467 = ₹23,350. Total Present Value of Inflows = ₹2,32,029 + ₹23,350 = ₹2,55,379. Net Present Value (NPV) = ₹2,55,379 − ₹3,46,500 = -₹91,121.

Since the NPV is negative, the replacement proposal is financially unviable over the 8-year cycle. When adjusted for unequal lives (old machine having 9 remaining years versus 8 years for the new asset) via the Equivalent Annual Annuity (EAA) approach, the annualized loss confirms that retaining the existing machine is value-maximizing.

(b) Risk-Return Trade-Off in Financial Decisions

The risk-return trade-off dictates that higher expected returns necessitate assuming greater risk. In corporate financial management, this governs three core decisions: In capital structure decisions, debt financing lowers the weighted average cost of capital due to the interest tax shield under Section 36(1)(iii) of the Income Tax Act, but elevates financial risk and bankruptcy costs compared to conservative equity financing. In working capital management, an aggressive policy (maintaining minimal current assets financed through short-term debt) enhances profitability and Return on Capital Employed (ROCE) at the cost of severe liquidity risk, whereas a conservative policy holds excess liquid buffers, depressing returns. In capital budgeting and portfolio selection, total risk splits into systematic risk (market-wide, non-diversifiable) and unsystematic risk (firm-specific, diversifiable). Sectoral capital allocation in India reflects this: low-risk, asset-light IT firms (e.g., Infosys, TCS) command stable cash flows and moderate returns, whereas long-gestation infrastructure and power projects (e.g., Adani Ports, NTPC) carry higher systematic regulatory and demand risk, demanding higher hurdle rates.

(c) Measurement and Effects of Combined Leverage

Degree of Combined Leverage (DCL) measures the total sensitivity of earnings per share (EPS) to variations in sales revenue. It synthesises operating leverage (fixed operating costs) and financial leverage (fixed financing charges): DCL = Degree of Operating Leverage (DOL) × Degree of Financial Leverage (DFL) DCL = (% Change in EBIT)/(% Change in Sales) × (% Change in EPS)/(% Change in EBIT) = (% Change in EPS)/(% Change in Sales) = (Contribution)/(EBT)

Numerical illustration: sales Rs 10,00,000 less variable costs Rs 6,00,000 give a contribution of Rs 4,00,000; fixed operating costs are Rs 1,50,000 so EBIT is Rs 2,50,000, and interest of Rs 50,000 leaves EBT of Rs 2,00,000. Then DOL = 4,00,000/2,50,000 = 1.60, DFL = 2,50,000/2,00,000 = 1.25, and DCL = 1.60 x 1.25 = 4,00,000/2,00,000 = 2.0. A 10% rise in sales therefore lifts EPS by 20%, and a 10% fall cuts EPS by 20%.

Combined leverage acts as a two-way multiplier. A high DCL accelerates EPS growth rapidly when sales expand above the financial break-even point. Conversely, during demand contractions, high fixed operating and interest costs cause a steep drop in profitability, magnifying default risk.

In India, capital-intensive conglomerates such as Tata Steel and Reliance Industries, as well as telecom operators (e.g., Vodafone Idea), operate with high DCL due to heavy plant depreciation and high debt servicing. When capacity utilisation drops, these firms experience sharp drops in net earnings, demonstrating why firms with high operating leverage must temper their financial leverage to maintain solvency.

Verdict

On quantitative evaluation, the negative NPV of ₹91,121 establishes that the old machine should not be replaced. Strategically, corporate financial health requires maintaining an optimal leverage mix that balances tax shields against downside financial distress.