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Relevance and Controllability (LO1, LO2)

Exactly one year ago, Gamma Machinery purchased a lathe for $300,000. At the time of purchase, Gamma expected the lathe to generate a net cash inflow of $120,000 per year for three years. Recently, another firm located in the same industrial park went into bankruptcy. The bankrupt firm’s liquidators have offered to sell their client’s sophisticated lathe to Gamma for $400,000, even though their client paid $800,000 for it one year ago. The bankrupt firm’s lathe has a superior control system that would significantly improve Gamma’s machining capabilities. Moreover, if Gamma replaces its current lathe, it will be able to increase its net cash inflow to $250,000 per year for each of the next two years. If Gamma purchases the lathe, the company can either retain its current lathe for miscellaneous jobs or sell it. The miscellaneous jobs will produce an additional net cash inflow of $50,000 per year for the next two years. Gamma can sell its current lathe today for $170,000. Both lathes will be worth $0 in two years. Gamma must decide whether to purchase the bankrupt firm’s lathe and, if it does, what to do with its own lathe. Gamma’s goal is to maximize its net cash flow over the next two years.

Required:
a. Identify Gamma’s decision options. Is the status quo a feasible option?

b. What are the relevant and controllable costs and benefits for Gamma’s decision?

c. Assume that Gamma is committed to buying the new lathe. Thus, the status quo is not a feasible option. In this case, what are the controllable and relevant costs and benefits for Gamma’s decision regarding the current lathe?

Answer :

Gamma Machinery has to decide whether to purchase the bankrupt firm's lathe and what to do with its current lathe to maximize its net cash flow over the next two years.

a. Gamma's decision options are: (1) do nothing and continue using the current lathe; (2) purchase the bankrupt firm's lathe and sell the current lathe; (3) purchase the bankrupt firm's lathe and retain the current lathe for miscellaneous jobs.

b. The relevant and controllable costs and benefits for Gamma's decision include: the cost of purchasing the bankrupt firm's lathe ($400,000), the net cash inflow from the current lathe for the next two years ($120,000 per year), the net cash inflow from the new lathe for the next two years ($250,000 per year), the net cash inflow from the current lathe for miscellaneous jobs for the next two years ($50,000 per year), and the proceeds from selling the current lathe ($170,000).

c. If Gamma is committed to buying the new lathe, the relevant and controllable costs and benefits for its decision regarding the current lathe include: the net cash inflow from the current lathe for miscellaneous jobs for the next two years ($50,000 per year) and the proceeds from selling the current lathe ($170,000). The decision is whether to sell the current lathe or retain it for miscellaneous jobs, depending on which option generates a higher net cash inflow.

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