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 four 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 7,600 ships:

Direct materials	$27,740
Direct labor	26,600
Variable overhead	13,300
Fixed overhead	33,060
Total	$100,700

The cost of the new equipment is $130,000. It has a four 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 $2.00 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 increase by $3,600.

Finley expects production to be 8,100 ships in each of the next four 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

= $27740+26600+13300 = $67640

Variable cost per ship using old machine= 67640/7600 = $8.90

Variable cost to produce one ship using new machine = 8.90-2.00+0.23 = $7.13

Fixed cost in case of new machine = 33060 + 3600 = $36660

Present value of cost (old machine) = (Variable cost+Fixed cost )*present value factor 5%, 4 years

= (8.90*8100 + 33060)*3.5460

= $372862

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

= (7.13*8100+36660)*3.5460 +(130000-25000) - 30000*0.8227

= $415107

1. Difference in net present value (excess cost) = 372862-415107

= $-42245