Nautical Creations is one of the largest producers of miniature ships in a bottl
ID: 2450243 • Letter: N
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 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 four 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 8,000 ships:
The cost of the new equipment is $145,000. It has a four 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 to be reduced by a total of $2.20 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 $0.19 more per unit. Fixed overhead costs will increase by $4,800.
Finley expects production to increase to 8,550 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?
Explanation / Answer
Calculation of Net Present Value of of Invetment decision by Nautical Creations Year Cash outflow Net Cashinflows Discount Factor (@5%) Discounted Cashflow 0 $ -1,45,000 $ 40,000 1.00 $ -1,05,000 1 $ 12,386 0.95 $ 11,796 2 $ 12,386 0.91 $ 11,234 3 $ 12,386 0.86 $ 10,699 4 savings including salvage value $ 47,386 0.82 $ 38,984 Total Net Present Value $ -32,287 Savings in Total Manufacturing cost with the new equipment Base Savings (Additional cost) Direct Mater 8,550 x $ 0.19 $ -1,625 Direct Labour and Variable overhead 8,550 x $ 2.20 $ 18,810 Increase in Fixed overhead $ -4,800 Total Savings in each of the four years $ 12,386 Conclusion: By Investing in the new machine,Nautical Creations earns a negative net present value of $ 32,287. But before taking a decision, the increase in revenue due to increase in production also to be taken in to account (assuming selling price is constant). Further, in the analysis, only factors relevant to decision making are considered. Only increase in fixed over head is considered as the fixed overhead will not change due to increase or decrease in operations.
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