(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 life was 15 years with no salvage value. If this machine is replaced by a new machine costing ₹ 4,50,000, the operating cos

Question

(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 life was 15 years with no salvage value. If this machine is replaced by a new machine costing ₹ 4,50,000, the operating cost would be reduced by ₹ 60,000 for the next 10 years. The old machine could also be sold for ₹ 10,000. The cost of capital is 10%. The new machine will be depreciated on straight line basis over eight years life with ₹ 50,000 as salvage value.

Assuming the company's tax rate to be 55% and using the NPV method, state whether the old machine should be replaced or not.

The present value factor at 10% is as follows :

| Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 |
| PVF | 0·909 | 0·826 | 0·751 | 0·683 | 0·621 | 0·564 | 0·513 | 0·467 | 20

(b) Discuss the risk-return trade-off in financial decisions. Give examples. 15

(c) How will you measure the degree of combined leverage ? Also describe the effects of combined leverage along with suitable examples. 15

UPSC Answer Check · Accepted Answer

The directive 'evaluate' requires critical assessment of the replacement decision through quantitative analysis and qualitative discussion. Allocate approximately 40% time to part (a) for detailed NPV calculations with tax shields and incremental cash flows; 30% each to parts (b) and (c) for conceptual discussion with Indian corporate examples. Structure: begin with calculation framework for (a), followed by theoretical exposition with real-world illustrations for (b) and (c), ending with integrated conclusions on capital budgeting and leverage decisions.
- Part (a): Calculate incremental initial outlay (₹4,50,000 - ₹10,000 sale + ₹93,500 tax on loss = ₹5,33,500), annual depreciation tax shields (new: ₹55,000; old: ₹20,000), incremental operating cash flows post-tax, terminal cash flows, and NPV comparison over 8 years
- Part (a): Correct application of tax on capital loss (₹1,80,000 - ₹10,000 = ₹1,70,000 × 55% = ₹93,500) and proper treatment of unequal lives using replacement chain or equivalent annual annuity approach
- Part (b): Explanation of risk-return trade-off principle—higher expected returns require assumption of greater risk; discussion of systematic vs. unsystematic risk in capital budgeting and portfolio decisions
- Part (b): Examples from Indian context: equity vs. debt financing decisions, aggressive vs. conservative working capital policies, or sectoral comparisons (IT vs. infrastructure investments)
- Part (c): Formula for degree of combined leverage (DCL = DOL × DFL or % change in EPS/% change in sales) with clear derivation from operating and financial leverage components
- Part (c): Effects of combined leverage—magnification of both returns and risks; examples such as capital-intensive Indian firms (Tata Steel, Reliance) or highly leveraged sectors (real estate, telecom)

Dimension	Weight	Max marks	Excellent	Average	Poor
Demand-directive understanding	20%	10	Demonstrates precise understanding that 'evaluate' in (a) requires definitive replacement decision with numerical justification, while (b) and (c) demand critical discussion with balanced risk-return analysis; correctly interprets all three directive variations (calculate, discuss, describe) and integrates them into cohesive response	Shows basic grasp of evaluation requirement but treats (a) as mere calculation without decision framing; discusses risk-return and leverage in generic terms without clear directive alignment	Misinterprets directives—provides only calculations without conclusion for (a), or lists definitions without discussion for (b) and (c); fails to recognize evaluative nature of question
Content depth & accuracy	20%	10	Part (a): flawless NPV computation with correct tax-adjusted cash flows, proper handling of capital loss tax benefit, accurate PVF application, and correct replacement decision; Parts (b)-(c): comprehensive theoretical exposition with precise formulas, clear distinction between leverage types, and sophisticated risk analysis	Minor computational errors in (a) such as incorrect tax shield calculation or PVF misapplication; adequate theoretical coverage in (b)-(c) but missing nuances like interaction effects between operating and financial leverage	Major errors in (a): omits tax on capital loss, uses wrong depreciation base, or fails to discount cash flows; superficial or incorrect treatment of leverage formulas and risk concepts in (b)-(c)
Structure & flow	20%	10	Presents (a) with clear step-wise calculation format (initial outlay, annual flows, terminal flows, NPV summary); organizes (b) and (c) with logical progression from concept to measurement to implications; uses tables effectively and maintains cross-referencing between numerical and theoretical components	Readable structure with identifiable sections but inconsistent formatting; calculations present but not optimally organized; theoretical parts follow basic introduction-body-conclusion without sophisticated integration	Disorganized presentation with mixed calculations and theory; missing headings or clear part demarcations; difficult to follow logical progression or locate specific answers
Examples / case-law / data	20%	10	For (b): specific Indian examples such as Infosys's conservative capital structure vs. Suzlon's aggressive leverage, or RBI monetary policy impact on corporate risk-return decisions; For (c): concrete DCL calculations for Indian companies (e.g., Maruti Suzuki vs. Tata Motors) or sectoral leverage comparisons with data	Generic examples without Indian specificity (e.g., 'a manufacturing company'); mentions real firms but without accurate leverage data or contextual relevance; examples illustrate concepts adequately but lack precision	No examples provided for (b) and (c), or irrelevant/inaccurate illustrations; fails to connect theoretical discussion to practical financial decision-making in Indian context
Conclusion & analytical edge	20%	10	For (a): explicit replacement recommendation with sensitivity awareness; synthesizes across all parts to highlight interdependence—how leverage affects cost of capital in (a), how risk-return trade-off influences leverage decisions; offers policy insights for capital budgeting under uncertainty	Clear conclusion for (a) with stated decision; separate adequate conclusions for (b) and (c) but minimal cross-part synthesis; limited forward-looking or policy-oriented analysis	Missing or vague conclusion for (a); no recommendation or incorrect decision based on calculations; isolated treatment of parts without recognition of thematic connections; purely descriptive ending without analytical depth

(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…

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