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 $20,000. The following are last year's total manufacturing costs, when production was 9,000 ships:
Direct materials: $32,400
Direct labor: 31,950
Variable overhead:15,750
Fixed overhead: 39,150
Total: $119,250
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 $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 $1.90 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 $4,000.
Finley expects production to be 9,450 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?
Solution :
| Computation of Annual cost saving on new equipment | |
| Particulars | Amount |
| Saving in direct labor and variable overhead (9450*$1.90) | $17,955.00 |
| Decrease in fixed overhead cost | $4,000.00 |
| Additional cost of direct material (9450*$0.15) | -$1,417.50 |
| Net Annual Saving | $20,537.50 |
| Computation of NPV - Replacement proposal of equipment - Nautical Creations | ||||
| Particulars | Period | Amount | PV Factor | Present Value |
| Cash Outflows: | ||||
| Cost of new equipment | 0 | $135,000.00 | 1 | $135,000 |
| Sale value of old equipment | 0 | -$20,000.00 | 1 | -$20,000 |
| Present value of cash outflows (A) | $115,000 | |||
| Cash Inflows | 1-6 | $20,537.50 | 5.07569 | $104,242 |
| Salvage value of new machine | 6 | $50,000.00 | 0.74622 | $37,311 |
| Present value of cash Inflows (B) | $141,553 | |||
| NPV (B-A) | $26,553 |
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