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 $25,000. The following are last year's total manufacturing costs, when production was 8,400 ships:

Direct materials	$30,660
Direct labor	29,400
Variable overhead	13,020
Fixed overhead	39,060
Total	$112,140

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 $50,000. 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 $0.23 more per unit. Fixed overhead costs will increase by $4,700.

Finley expects production to be 9,000 ships in each of the next four years. Assume a discount rate of 5%.

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

Statement of Present Value of Cash Flow
	0	1	2	3	4
Cost of New Equipment	$      (140,000)
Sale of Old Equipment	$         25,000
Annual Saving from New Equipment		$12,130	$12,130	$12,130	$12,130
Disposal value of New Equipment					$50,000
Total Cash Flow	$      (115,000)	$    12,130	$    12,130	$    12,130	$    62,130
Present Value Interest factor (5%)	$                  1	0.9524	0.907	0.8639	0.8227
Present Value of Cash Flows	$      (115,000)	$    11,553	$    11,002	$    10,479	$    51,114

Difference in NPV = ($115000) + $11553 + $11002 + $10479 + $51114 = $(30852)

Statement of Annual Saving from New Equipment
Reduce Direct Labor & Variable OH per unit	$2.10
Increase Direct Material per unit	$ (0.23)
Net Saving per unit	$1.87
Annual production in units	9000
Total Saving in Variable cost (A)	$16,830
Increase Fixed cost (B)	$4,700
Annual Saving from New Equipment (A-B)	$12,130