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. (As discussed in Chapter 1, the goal of maximizing profits is, in the long run, equivalent to the goal of maximizing cash flows).

Note: A lathe is a machine tool that spins a block of material, such as steel or wood, about a horizontal axis. Applying cutting tools to the block produces an object symmetric with respect to the axis of rotation. Sophisticated lathes use many tools and can shape the material along all three axes. Examples of products produced using lathes include candlesticks, table legs, and baseball bats.

Required:

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

b. What are the controllable and relevant 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?