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 8,200 ships:

Direct materials	$29,930
Direct labor	30,340
Variable overhead	12,710
Fixed overhead	37,310
Total	$110,290

The cost of the new equipment is $140,000. It has a six year useful life with an estimated disposal value at that time of $35,000. 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 $2.25 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 $3,000.

Finley expects production to be 8,700 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

In order to calculate the Difference in Net Present Value (NPV) between buying new equipment and keeping the current equipment, we would need to calculate the Cost that would be incurred for producing 8700 ships per year for the next 6 years: 1) if using the current equipment and 2) if using the new equipment. This calculation is shown below:

Based on the costs computed above, we can now calculate the NPVs and their differences as follows: