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 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 8,800 ships: Direct materials $33,000 Direct labor 30,800 Variable overhead 14,080 Fixed overhead 41,360 Total $119,240 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 $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 $2.15 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 decrease by $4,200. Finley expects production to be 9,250 ships in each of the next six years. Assume a discount rate of 5%.

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

Answer 1

In the question we are not given the cash flows or sales to find profit but the expense. so we will find the present value of expense and the machine having lower expense npv will be selected. as lower expense with same level of production should be favorable.

we will also assume that the old machine will produce 9250 units in the next 6 years and not 8800 units like previous year.

discount factor = 5%

calculation of npv of of expense of old machine

calculation of expense from old machine

expected units produced = 9250

direct material and labor : 3.75+3.5= 7.25

variable overhead : 1.6

total variable expenses = [3.75+1.6]*9250 = 49487.5

fixed overhead = 41360

depreciation = 5000 (30000/6)

total expenses = 49487.5+ 41360 + 5000

total expenses = 95847.5

year	expense	pv factor	present value
1	95847.5	0.952	91246.82
2	95847.5	0.907	86933.68
3	95847.5	0.864	82812.24
4	95847.5	0.823	78882.49
5	95847.5	0.784	75144.44
6	95847.5	0.746	71502.24

net present value (expenses) = 486521.9

calculation of expense per unit ( working note)

units produced

direct material per unit = 33000/8800

=3.75

direct labor per unit = 30800/8800

=3.5

variable overhead per unit = 14080/8800

=1.6

depreciation expense per year= value as per 2020/ expected life remaining

=30000/6

=5000

CALCULATION OF NET PRESENT VALUE OF EXPENSES USING NEW MACHINE

calculation of expense

direct material and labor per unit = 5.1+0.3=5.33

variable overhead per unit = 1.6

fixed overhead = 37160

depreciation = 16666.66 per year

total variable expenses = (5.33+1.6)*9250 = 64102.5

total expense = 64102.5 + 37160 + 16666.66

total expense = 117929.16

year	expense	pv factor	present value
0	145000-30000=115000	1	115000
1	117929.16	0.952	112268.6
2	117929.16	0.907	106961.7
3	117929.16	0.864	101890.8
4	117929.16	0.823	97055.7
5	117929.16	0.784	92456.46
6	117929.16	0.746	87975.15

present value of salvage value after 6 years = 45000*0.746=33570

net present value (expenses) = 713608.4-33570

which is 680038.4

Difference in net present value of expenses is 193516.5

working notes for new machine

direct material and labor per unit = 7.25 - 2.15 + 0.23= 5.33

variable overhead will remain the same as 1.6

fixed overhead = 41360 - 4200 = 37160

depreciation per year = (cost - salvage value) / 6

=(145000-45000)/6

=16666.66

as npv of expenses is higher with new machine the old machine should be used to increase profitability.