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 $30,000. The following are last year's total manufacturing costs when production was 8,200 ships:

Direct materials	$31,980
Direct labor	29,110
Variable overhead	15,170
Fixed overhead	37,720
Total	$113,980

The cost of the new equipment is $135,000. It has a six-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 $1.95 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 $4,400.

Finley expects production to be 8,750 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

NET SAVINGS IN COST:
Net savings in Variable cost:
Savings in labour and variable OH				1.95 PER UNIT
Less: Increase in material ccost				0.21 per unit
Net saving in variable cocst per unit				1.74 per unit
Total savings in Variable cost (8750*1.74)				15225
Add: savings in fixed cost				4400
Total savings with use of Newe equipment				19625
Present value of Annual savings ($ 19625 * Preset annuity factor for 6 yrs i.e. 5.4172									106312.6
Add: Present value of Salvage value of New Equipment ($ 30,000* Present value factor i.e. 0.8375)									25125
				Total Present value of Inflows					131437.6
			Less: Net initial investment (135000-30000)						105,000
				Ndt present value					26,438
				Hence, New equipment shall be installed.
Note: Increase in production is the management decision and is not related to new equipment.