Question

Nautical Creations is one of the largest producers of miniature ships in a bottle. An especially complex part of one of the ships needs special production equipment that is not useful for other products. The company purchased this equipment early in 2016 for $200,000. It is now early in 2020, and the manager of the Model Ships Division, Jeri Finley, is thinking about purchasing new equipment to make this part. The current equipment will last for four more years with zero disposal value at that time. It can be sold immediately for $30,000. The following are last year's total manufacturing costs, when production was 7,600 ships:

Direct materials	$29,640
Direct labor	29,260
Variable overhead	12,920
Fixed overhead	35,720
Total	$107,540

The cost of the new equipment is $140,000. It has a four year useful life with an estimated disposal value at that time of $35,000. The sales representative selling the new equipment stated, "The new equipment will allow direct labor and variable overhead combined to be reduced by a total of $2.10 per unit." Finley thinks this estimate is accurate, but also knows that a higher quality of direct material will be necessary with the new equipment, costing $0.15 more per unit. Fixed overhead costs will increase by $3,300.

Finley expects production to be 8,000 ships in each of the next four years. Assume a discount rate of 3%.

Question:

1. What is the difference in net present values if Nautical Creations buys the new equipment instead of keeping their current equipment? (FYI: $61,170 is not a possible answer)

Answer 1

(1) We will first fine initial outlay

=cost of new equipment-sale value of old equipment

=$140,000-$30,000

=$110,000

(2) Now, we will find net savings due to new machine

= ($2.10-$0.15) per ship *8,000 ships per year -increase in fixed cost $3,300

=$12,300

(3) now we will determine year wise cash flows

Year 0 =($110,000)

Year 1 =$12,300

Year 2 =$12,300

Year 3 =$12,300

Year 4 =$($12,300+salvage $35,000)

=$47,300

(4) NPV

Year	Cash flow	PV factor @3%	Presnet value of cash flows
0	($110,000)	1	($110,000)
1	$12,300	0.9708737[1/1.03]^1	$11,941.75
2	$12,300	0.9425959[1/1.03]^2	$11,593.93
3	$12,300	0.915141659[1/1.03]^3	$11,256.24
4	$47,300	0.8884870[1/1.03]^4	$42,025.44
		Net Present Value	$33,182.64[$11,941.75+$11,593.93+$11,256.24+$42,025.44-110,000]

Thus, NPV of buying new equipment INSTEAD OF CURRENT SYSTEM IS -$33,183

It is negative hence new machien should not be purchased.