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 $25,000. The following are last year's total manufacturing costs, when production was 7,200 ships: Direct materials $26,280 Direct labor 25,920 Variable overhead 11,520 Fixed overhead 30,960 Total $94,680 The cost of the new equipment is $150,000. 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 $2.15 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 $0.15 more per unit. Fixed overhead costs will decrease by $3,500. Finley expects production to be 7,650 ships in each of the next six years. Assume a discount rate of 3%. What is the difference in net present values if Nautical Creations buys the new equipment instead of keeping their current equipment?

Answer 1

Solution and Explanation:

Annual savings in cost:  

Savings in Labour and OH cost (8500 units at 2.20)              18700

Add: Savings in fixed cost                                           4400

Less: Increase in material cost (8500 units at  0.25)                 2125

Net annual savings in cost                                         20975

Present annuity factor for 6 years at 5%                        5.0757

Present value of Annual savings in cost                     106462.8

Add: Present value of Salvage value of new equipment        22386

($ 30,000 with PVF at 0.7462)    

Add: Salvage value of existing machine                        30,000

Total Present value of cash inflows                               158,849

Less: Initial investment                                              145,000

Net present value                                                    13,849