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 2015 for $200,000. It is now early in 2019, 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 $20,000. The following are last year's total manufacturing costs, when production was 7,800 ships:

Direct materials	$30,810
Direct labor	29,250
Variable overhead	14,430
Fixed overhead	34,320
Total	$108,810

The cost of the new equipment is $135,000. It has a four 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 $2.05 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 $0.25 more per unit. Fixed overhead costs will increase by $4,600.

Finley expects production to be 8,400 ships in each of the next four years. Assume a discount rate of 3%.

Answer 1

Solution

Nautical Creations

Determination of the difference in net present values if the company buys the new equipment instead of keeping their current equipment:

Keeping the current equipment –

The present value of keeping the current equipment = $20,000

The disposal value at the end of 4 years from now = 0

Total cost of goods sold for each of the 4 years = ($108,810/7,800) x 8,400 = $13.95 x 8,400 = $117,180

Purchases new equipment –

The present value of the new equipment = $135,000

The disposal value at the end of 4 years = $30,000

Total cost of goods sold for each of the four years = (current per unit production cost + increase in direct materials cost – decrease in labor and overhead cost) x expected units per year + increase in fixed overhead cost

= ($13.95 + $0.25 - $2.05) x 8,400 + $4,600

= $106,660

Incremental cash outflows if the company purchases new equipment instead of keeping the current equipment,

At, period, N = 0, the cash outflow = $135,000 - $20,000 = $115,000

Cash inflow, as regards the disposal value of new equipment = $30,000

Incremental cash inflows resulting from cost savings in cost of goods sold for each of the 4 years = $117,180 - $106,660 = $10,520

Computation of NPV at 3% discount rate,

Present value of incremental cash outflows = $115,000

Present value of incremental cash inflows = present value of annual cost savings + present value of disposal value at end of fourth year

= $10,520 x (P/A, 3%, 4) + $30,000 (P/F, 3%, 4)

= 10,520 x (3.717) + 30,000 x (0.8885) = $39,103 + $26,655

Present value of incremental cash inflows = $65,758

Net present value = $65,758 - $115,000 = ($49,242)

Hence, the difference in net present values if Nautical Creations buys the new equipment instead of keeping the current equipment is ($49,242).

The purchase of new equipment is not profitable to Nautical Creations as the NPV is negative.