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 $40,000. The following are last year's total manufacturing costs, when production was 7,600 ships:

Direct materials	$30,020
Direct labor	26,980
Variable overhead	12,160
Fixed overhead	35,720
Total	$104,880

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 $3,000.

Finley expects production to be 8,200 ships in each of the next six years. Assume a discount rate of 5%.

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

Total variable cost = Direct material + Direct labor + variable overhead

= $30020+26980+12160 = $69160

Variable cost per ship using old machine= 69160/7600 = $9.10

Variable cost to produce one ship using new machine = 9.10-2.15+0.15 = $7.10

Fixed cost in case of new machine = 35720-3000 = $32720

Present value of cost (old machine) = (Variable cost+Fixed cost )*present value factor 5%, 6 years

= (9.10*8200 + 35720)*5.0757

= $560053

Present cost (New machine) = (Variable cost+ Fixed cost)*Present value factor + Initial net investment - Present value of salvage value

= (7.10*8200+32720)*5.0757 +(150000-40000) - 50000*0.7462

= $534274

1. Difference in net present value (cost savings) = 560053-534274

= $25779