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 8,200 ships: Direct materials $31,570 Direct labor 29,110 Variable overhead 12,300 Fixed overhead 37,310 Total $110,290 The cost of the new equipment is $140,000. It has a six year useful life with an estimated disposal value at that time of $45,000. 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 $2.20 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 $0.21 more per unit. Fixed overhead costs will decrease by $3,600. Finley expects production to be 8,700 ships in each of the next six years. Assume a discount rate of 5%.What is the difference in net present values if Nautical Creations buys the new equipment instead of keeping their current equipment?

Answer 1

Scenario I: The company doesn’t procure new equipment and shall be continuing with the existing equipment. The following are the information on the expenses for last year when production was 8200 units (ships).

Particulars	Cost	Cost / unit
Direct materials	31,570	3.85
Direct Labor	29,110	3.55
Variable O/H	12,300	1.5
Fixed O/H	37,310
TOTAL	110,290

Considering the company shall manufacture 8700 ships for next six years, the total operational expenses in line with the above table shall be $114,740 per annum.

Scenario II: The company disposes the old equipment at $40,000 and purchases new equipment at $140,000, which is expected to have a disposal value of $45,000 at the end of sixth year. The following are the information on the expected expenses on account of purchase of new equipment.

Particulars	Cost	Cost / unit
Direct materials		3.85 + 0.21 = 4.06
Direct Labor + Variable O/H		3.55 + 1.5 – 2.20 = 2.85
Fixed O/H	37,310 – 3600 = 33,710

Considering the company shall manufacture 8700 ships for next six years, the total operational expenses in line with the above table shall be $93,827 per annum.

The following table compares the NPV of both the scenarios at 5% discount rate. For scenario II, there are additional expenses and additional income considering the cost of the investment and salvage values of old and new equipment.

Years	Scenario I	Scenario II
0	0	-100,000	-140,000 + 40,000
1	-114,740	-93,827
2	-114,740	-93,827
3	-114,740	-93,827
4	-114,740	-93,827
5	-114,740	-93,827
6	-114,740	-48,827	-93,827 + 45,000
NPV@5%	-554,652.29	-516,816.44