This is a decision to keep or replace current equipment, mutually exclusive alte

Question

This is a decision to keep or replace current equipment, mutually exclusive alternatives. The question asks for the difference in the net present values of the two alternatives, not the net present value of one or the other. Use the present value tables on page 118 to compute present values.
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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 2012 for $200,000. It is now early in 2015, 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 per-unit manufacturing costs, when production was 8,800 ships:

The cost of the new equipment is $130,000. 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 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 increase to 9,400 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?

Direct materials $3.85 Direct labor 3.75 Variable overhead 1.75 Fixed overhead 4.30 Total unit cost $13.65

Explanation / Answer

Inflows if old equipment sold immediately

Working 1:

Inflows if old equipment sold immediately

Amount$ Saving in direct labor and variable overhead(2.25*8800) 19800 Less: Additional cost of direct material(0.23*8800) -2024 Add: Saving in Fixed Costs 3000 Total inflow per year for 6 years 20776 Present value of inflows(Please see working 1) 105452.5784 Outflows if old equipment sold immediately Amount$ Cost of new equipment 130000 Less: Sale of current equipment -40000 Less: Present value of disposal @5%- 50000/1.05^6 -37310 Present value of Outflow 52690 Net Present Value( Present values of inflows- outflows) 52762.57839

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