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 7,600 ships:

The cost of the new equipment is $145,000. It has a six 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 $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 $0.17 more per unit. Fixed overhead costs will decrease by $4,300.

Finley expects production to increase to 8,000 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 $3.60 Direct labor 3.55 Variable overhead 1.55 Fixed overhead 4.70 Total unit cost $13.40

Explanation / Answer

The problem is silent on the Sale Price of 1 Ship. Hence, profit for the the two alternatives ie: With the Old Equipment for 7600 units and with the New Equipment for 8000 units cannot be considered.

Hence, the total cost with the old equipment and the new equpment has been calculated and the savings in cost taken as the Cash Inflow for the 6 years as an annuity.

    This is 101,840 - 81,732 = $ 20,108 (Calculations of cost shown in workings given at the end)

The Cash Outflow at t0 for buying the new equipment = 145,000 - 40,000 (Salvage of Old Equipment) = $ 105,000

The terminal Cash inflow at the end of the sixth year = $ 35,000

The Net Present Value of the incrementatl cash flows can be found out by

    20108 * PVIFA 5,6 + 35000 * PVIF 5,6 - 105,000 = 20108 * 5.076 + 35000 * .746 - 105,000 = 128178 - 105000

                                                  = $ 23,178 This is the NPV if the firm goes for the New Equipment

As the NPV of the incremental cash flows is + ve, the firm should replace the old equipment.

                      Working of Cash Flows per Year For Existing Machine For New Machine            7600 Units            7600 Units Unit Cost Total Cost Unit Cost Total Cost Direct Material 3.6 27360 Direct Material 3.77 28652 Direct Labour 3.55 26980 Direct Labour & VOH 2.85 21660 Variable OH 1.55 11780 Fixed Overhead 4.70 35720 Fixed Overhead 31420     Total Cost 101840 Total Cost 81732

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