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 $40,000. The following are last year's total manufacturing costs, when production was 7,800 ships:

Direct materials	$28,860
Direct labor	29,250
Variable overhead	12,480
Fixed overhead	34,320
Total	$104,910

The cost of the new equipment is $150,000. It has a four year useful life with an estimated disposal value at that time of $30,000. 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 $4,900.

Finley expects production to be 8,200 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

Answer is given below

8,200 $17,220 $2.10 per unit units sale per year savings in direct material and labor Less: Increase in direct material cost Increase in fixed cost Incremental savings $1,886 $0.23 per unit $4,900 $10,434 cost of new equipment Less: sales value of existing machine Net cost of new equipment $150,000 -$40,000 $110,000 Calculation of Net present value Annual Cash Inflow Annuity PV Factor 5% Present Value $10,434 $30,000 3.5460 0.8227 Incremental savings Salvage value Total PV of Cash Inflows Less: Net Initial investment Net Present value $36,998 $24,681 $61,680 $110,000 -$48,320 The net present value is negative. Hence the new equipment should not be purchased