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 2012 for $200,000. It is now early in 2016, 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 7,400 ships:

Direct materials	$28,860
Direct labor	27,010
Variable overhead	12,950
Fixed overhead	32,560
Total	$101,380

The cost of the new equipment is $145,000. It has a four 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 to be reduced by a total of $2.00 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 increase by $3,100.

Finley expects production to increase to 7,800 ships in each of the next four years. Assume a discount rate of 3%.

1. What is the difference in net present values if Nautical Creations buys the new equipment instead of keeping their current equipment?

Answer 1

Incremental Initial Investment required for new equipment = Cost of new equipment - Selling Price of old equipment

= $145,000 - 25,000 = -$120,000

Annual Cost Benefit due to new equipment for next 4 years= (Reduction in Direct Labour cost / unit + Reduction in Variable Overhead cost/ unit - Increase in Direct Material Cost /unit)*Units expected to be produced - Increase in Fixed Overheads Costs

= $(2.00 + 2.00 - .21)*7,800 - 3,100 => $26,462

Terminal Value of the Cashflow at the end of 4 years = Disposal Value of Equipment

= $45,000

Difference in Net Present Value if Nautical Creations buys the new equipment instead of keeping their current equipment = -Incremental Initial Investment + Present values of Annual Cost Benefits for 4 years +Terminal Value of the Cashflow at Time 4

= -120,000 + 26,462/(1+ Discount Rate)^1 + 26,462/(1+ Discount Rate)^2 + 26,462/(1+ Discount Rate)^3 + 26,462/(1+ Discount Rate)^4 + 45,000/(1+ Discount Rate)^4

= -120,000 + 26,462/(1+ 3%) + 26,462/(1+ 3%)^2 + 26,462/(1+ 3%)^3 + 26,462/(1+ 3%)^4 +45,000/(1+ 3%)^4

= -120,000 + 25,691.3 + 24,942.9 + 24,216.5 + 23,511.1 + 39,981.9

= $18,343.7