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 2015 for $200,000. It is now early in 2019, 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 six 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 8,600 ships: Direct materials $33,970 Direct labor 31,390 Variable overhead 14,190 Fixed overhead 37,840 Total $117,390 The cost of the new equipment is $145,000. It has a six year useful life with an estimated disposal value at that time of $40,000. 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 $1.90 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 $0.23 more per unit. Fixed overhead costs will decrease by $4,800. Finley expects production to be 9,050 ships in each of the next six years. Assume a discount rate of 3%. REQUIRED 1. What is the difference in net present values if Nautical Creations buys the new equipment instead of keeping their current equipment?

Answer 1

Nautical Creations keeps the current equipment

• The present value (t=0) of the current equipment = $30,000
• The disposal value at the end of six years(t=6) from now = $0
• Also, total cost of goods sold for each of the six years = $117,390

Nautical Creations purchases the new equipment

• The present value (t=0) of the current equipment = $145,000
• The disposal value at the end of six years(t=6) from now = $40,000

Also, total cost of goods sold for each of the six years

• = (Existing per unit production cost + increase in direct material - decrease in labor & overhead) * revised number of units - decrease in fixed overhead
• = ($117,390 + $0.23(9050 Ships) - $2.05(9050 Shops) ) - $4,800
• =($117,390+$2,082-$18,552)-$4,800
• = $100,920

Incremental cash flows if Nautical purchases the new equipment instead of keeping the current one

• Here at time t=0, the cash outflow will be = $145,000 - $30,000 = $115,000
• Also, cash inflow due to disposal value at the end of six years(t=6) from now = $40,000
• Moreover, incremental cash inflows due to cost savings for each of the six years = $117,390 - $100,920 = $16,470

Now, the difference in net present value calculation with discount rate of 3% (i.e. 0.03) is shown below

Difference in net present value

=$16,470/1.03+$16,470/1.03²+$16,470/1.03³...............$16,470/1.03⁶+40000/1.03⁶−$115,000

=$7468

The difference in net present values if Nautical Creations buys the new equipment instead of keeping their current equipment is $7468.