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 2013 for $200,000. It is now early in 2017, 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 $40,000. The following are last year's total manufacturing costs, when production was 9,000 ships:

Direct materials	$33,750
Direct labor	34,200
Variable overhead	13,500
Fixed overhead	38,700
Total	$120,150

The cost of the new equipment is $150,000. 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 $0.25 more per unit. Fixed overhead costs will decrease by $5,000.

Finley expects production to be 9,450 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

Variable cost to produce 1 Ship using old machine:

Particulars	Amount
Direct materials	33750
Direct labour	34200
Variable over head	13500
Total variable cost (A)	81450
No of ships last year (B)	9000
Variable cost per ship (A/B)	9.05

There fore variable cost to produce a ship using old Machine is $9.05 and Fixed Cost is $38700.

Variable cost to produce 1 Ship using New machine:

Given in the question that labour and variable overhead cost will reduce by $1.9 and material cost will increase by $.025 per ship, hence a net savings of $1.65 (1.95-.25) will be available if we use new machine in place of Old machine.

Hence Variable cost to produce one unit of ship using new machine is $7.4 (9.05-1.65).

Also given that fixed cost savings is $5000 hence fixed cost in case of new machine is $33700.

1. Computation of Present value of Cost to be incurred if Old machine is used:

Annual production each year for the next 6 Years = 9450

(A) Annual variable cost to be incurred = 9450*9.05= $85522.5

(B) Annual fixed cost = 38700

Annual cost to be incurred = (A+B) = $124222.5

Given discount rate is 3%, hence Present value annuity factor at 3% for 6 Years is 5.41719

Therefore Present value of cost in case of Old machine = $124222.5*5.41719 = $672937.06

2. Computation of Present value of Cost to be incurred if New machine is Purchased:

Annual production each year for the next 6 Years = 9450

(A) Annual variable cost to be incurred = 9450*7.4= $69930

(B) Annual fixed cost = 33700

Annual cost to be incurred = (A+B) = $103630

Given discount rate is 3%, hence Present value annuity factor at 3% for 6 Years is 5.41719

Therefore Present value of cost = $103630*5.41719 = $561383.4

On purchasing a New mcahine Investment of $150000 is required and Old machine is sold for $40000 today, so a net investment of $110000 is required to be made today and also the new machine can be sold for $40000 at the end of 6th year which is a saving in cost.

Present value of $40000 to be received at the end of 6th year = 40000*(1/1.03)^6=40000*.837484=33500

Hence present Total costs to be incurred in case of New machine = $561383.4+$110000-$33500= $637883.4

Conclusion:

We observe that present value of cost to be incurred under New machine is $637883.4 which is Lower than cost to be incurred under Old machine which is $672937.06, the difference (Cost Savings) in NPV is $35053.66

Hence New Machine should be purchased.