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 used 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 $25,000. The following are last year's total manufacturing costs when production was 8,800 ships:

Direct materials	$34,320
Direct labor	32,560
Variable overhead	15,840
Fixed overhead	37,840
Total	$120,560

The cost of the new equipment is $145,000. It has a six-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 $2.20 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 $0.19 more per unit. Fixed overhead costs will decrease by $4,600.

Finley expects production to be 9,300 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

Production of 8800 ships using old machine
Particulars	Total Cost	Cost per unit
Direct Material	$        34,320	$              3.90
Direct Labor	$        32,560	$              3.70
Variable Overhead	$        15,840	$              1.80
Fixed Overhead	$        37,840
Total Cost	$     120,560
Total Variable cost per unit		$              9.40
If new equipment is purhased
Changes in the variable cost per unit
= 9.4 - 2.2 + 0.19
$                     7
Prodution of units	9300
Calculation of yearly costs
	Old Machine	New Machine
No. of ships produced	8800	9300
Variable cost per ship	$                  9	$                    7
Total Variable Costs	$        82,720	$          68,727
Fixed Overhead	$        37,840	$          33,240	= 37840 - 4600
Total Annual Costs	$     120,560	$       101,967

Calculation of Net Present Value
Year	Particulars	Old Machine			New Machine
		Cash Flow	Discounting Factor @ 3%	Discounted Cash Flow	Cash Flow	Discounting Factor @ 3%	Discounted Cash Flow
0	Purchase of Machinery				$              120,000	1	$     120,000
1 - 6	Total Cost of Production of Ships	$        120,560	5.42	$     653,435	$              101,967	5.42	$     552,661
6	Disposal of asset				$              (50,000)	0.84	$     (42,000)
	Net Present Value			$     653,435			$     630,661
	The difference between the net present value of both the options is				$                22,774
	It is advisable to buy the new machine because the net outflow is less as compared to the outflow from using the old machine