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 four 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 7,600 ships:

Direct materials	$27,740
Direct labor	28,880
Variable overhead	11,780
Fixed overhead	34,960
Total	$103,360

The cost of the new equipment is $130,000. 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 combined to be reduced by a total of $2.15 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 increase by $3,100.

Finley expects production to be 8,100 ships in each of the next four 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?

Answer 1

Solution:

Calculating the difference in Net Present Values if nautical creations buys the new equipment instead of keeping their current equipment

Particulars	Amount ($)
Incremental cash Inflow
Savings in Direct labour and Overhead (8100*2.15)	17415
Less:
Increased cost in material (8100* 0.23)	1863
Increased Fixed Overhead Cost	3100
Net cash Inflow	12452
Present value annuity factor of Net cash inflow (12452 * pvaf(5%,4years) (A)	44154 (12452*3.5459)
Incremental cash outflow
Purchase of new asset	130000
Less:
Inflow from sale of old asset	30000
Present value of Residual Value of New equipment at the end of four years (35000*pvf (5%, 4years))	28794 (35000*0.8227)
Net Cash outflow (B)	71206
Net present value (A – B)	(27052)

Since the Net present value is Negative ($ 27052) it is not feasible to purchase the new equipment

pvaf = present value annuity factor

pvf = present value factor

Note: If you have any doubts please comment. Thank you