Nautical Creations is one of the largest producers of miniature ships in a bottl

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 2013 for $200,000. It is now early in 2017, 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 $30,000. The following are last year's total manufacturing costs when production was 8,200 ships:

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 $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 $1.95 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 $0.21 more per unit. Fixed overhead costs will decrease by $4,400.

Finley expects production to be 8,750 ships in each of the next six years. Assume a discount rate of 3%.

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

NET SAVINGS IN COST: Net savings in Variable cost: Savings in labour and variable OH 1.95 PER UNIT Less: Increase in material ccost 0.21 per unit Net saving in variable cocst per unit 1.74 per unit Total savings in Variable cost (8750*1.74) 15225 Add: savings in fixed cost 4400 Total savings with use of Newe equipment 19625 Present value of Annual savings ($ 19625 * Preset annuity factor for 6 yrs i.e. 5.4172 106312.6 Add: Present value of Salvage value of New Equipment ($ 30,000* Present value factor i.e. 0.8375) 25125 Total Present value of Inflows 131437.6 Less: Net initial investment (135000-30000) 105,000 Ndt present value 26,438 Hence, New equipment shall be installed. Note: Increase in production is the management decision and is not related to new equipment.

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