Suryan Foods: Replacing the Pasteuriser
Suryan Foods Ltd runs a dairy plant with a 10-year-old pasteuriser. Its book value is ₹8 lakh and it can be sold now for ₹5 lakh. If retained for four more years it will need maintenance of ₹18 lakh a year and will cause downtime losses of ₹6 lakh a year. A new pasteuriser costs ₹70 lakh, has a four-year life and would reduce maintenance to ₹6 lakh, eliminate downtime losses and save ₹9 lakh of power a year. Depreciation is 25% on written-down value for tax. The company pays tax at 30% and uses a 12% WACC. The new unit can be sold for ₹10 lakh at the end of year 4; the old unit would fetch nothing then. The plant has enough taxable profit to use all tax shields. The production head wants to order immediately because the old unit is unreliable, but the CFO wants an incremental free cash flow analysis. The power manager notes that the freed power capacity could be used for a new product line, but no decision on that line has been taken.
1. Compute the incremental initial outlay and annual after-tax operating cash flows for years 1–4, showing the depreciation tax shield. State the tax treatment of the old machine's sale.
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Tax on sale of the old machine: book value ₹8 lakh, sale ₹5 lakh, loss ₹3 lakh; tax shield at 30% = ₹0.9 lakh. Net initial outlay = 70 − 5 − 0.9 = ₹64.1 lakh.
Pre-tax operating savings = maintenance (18 − 6) = 12 + downtime 6 + power 9 = ₹27 lakh. After tax = 27 × 0.7 = ₹18.9 lakh.
Incremental depreciation:
- New: Y1 17.500; Y2 13.125; Y3 9.844; Y4 7.383
- Old: Y1 2.000; Y2 1.500; Y3 1.125; Y4 0.844
- Incremental: 15.500; 11.625; 8.719; 6.539
Tax shield at 30%: 4.650; 3.488; 2.616; 1.962.
After-tax operating cash flow: Y1 23.550; Y2 22.388; Y3 21.516; Y4 20.862 before the terminal flow.
2. Compute the terminal cash flow at the end of year 4 and the NPV at 12%. Recommend whether to replace, noting two qualitative factors.
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WDV of the new machine at the end of year 4 = 70 − (17.5 + 13.125 + 9.844 + 7.383) = ₹22.148 lakh. Sale at ₹10 lakh gives a loss of ₹12.148 lakh; tax shield at 30% = ₹3.644 lakh. Terminal cash flow = 10 + 3.644 = ₹13.644 lakh.
Total year-4 flow = 20.862 + 13.644 = ₹34.506 lakh.
NPV = −64.1 + 23.55/1.12 + 22.388/1.12² + 21.516/1.12³ + 34.506/1.12⁴ = −64.1 + 21.03 + 17.85 + 15.31 + 21.93 = ₹12.02 lakh.
The replacement adds about ₹12 lakh of value, so accept. Qualitatively, the old unit's unreliability may cause unquantified lost sales and food-safety risk, and the new unit may improve quality and reduce spoilage. Against that, the NPV is modest relative to the ₹70 lakh outlay, so a sensitivity check on savings is warranted.
3. The power manager says the freed power capacity could be used for a new product line, but no decision has been taken. How should the CFO treat this in the analysis? What information is needed?
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If the power capacity has a genuine alternative use, the ₹9 lakh power saving is not a pure benefit; it is the opportunity cost of not using the capacity. If the new line would generate a contribution greater than ₹9 lakh a year-or greater than the whole ₹27 lakh saving if power is the binding constraint-replacing the pasteuriser could destroy value relative to the alternative. The CFO should not add speculative value now; instead treat the new line as a mutually exclusive project and compare incremental NPVs. Needed information: available kW capacity, whether power is constrained at peak, capex and launch timing of the new line, its annual contribution and life, and whether both projects can proceed. If the new line is not approved, retain the ₹9 lakh saving; if it is approved, add the foregone contribution as a cost or evaluate the combined project.