Six months ago, Lee Anna Carver purchased a fire-engine red, used LeBaron conver

Question

Six months ago, Lee Anna Carver purchased a fire-engine red, used LeBaron convertible for $10,000. Lee Anna was looking forward to the feel of the sun on her shoulders and the wind whipping through her hair as she zipped along the highways of life. Unfortunately, the wind turned her hair into straw, and she didn't do much zipping along since the car spent so much of its time in the shop. So far, she has spent $1,200 on repairs, and she's afraid there is no end in sight. In fact, Lee Anna anticipates the following costs of restoration:
Rebuilt engine ......................... $1,250
New paint job ............................. 560
Tires ........................................ 460
New interior .............................. 500
Miscellaneous maintenance ............ 340
Total ................................... $3,110
On a visit to a used car dealer, Lee Anna found a five-year-old Honda CR-V in excellent condition for $9,100-Lee Anna thinks she might really be more the sport-utility type anyway. Lee Anna checked the Blue Book values and found that she can sell the LeBaron for only $3,600. If she buys the CR-V, she will pay cash but would need to sell the LeBaron.
Required:
1. In trying to decide whether to restore the LeBaron or buy the CR-V, Lee Anna is distressed because she has already spent $11,200 on the LeBaron. The investment seems too much to give up. How would you react to her concern?
2. List all costs that are relevant to Lee Anna's decision. What advice would you give her?

Explanation / Answer

Part 1)

In the given case, the amount spent towards purchase price ($10,000) and repair costs ($1,200) is not relevant to the decision making process. It is because these expenses have already been incurred and are therefore, treated as sunk costs irrespective of whether Lee Anna decides to restore the LeBaron or buy the CR-V. Lee Anna should take the decision on the basis of costs/expenses and benefits that may have to be incurred/obtained if LeBaron is retained or if CR-V is purchased.

_____

Part 2)

The following costs are relevant to Lee Anna's decision:

1) All future costs related to restoration of LeBaron (such as rebuilt engine, new paint job, tires, new interiors and miscellaneous maintenance costs).

2) Sales price of LeBaron ($3,600).

3) Net purchase price of CR-V [which would be $5,500 (9,100 - 3,600)].

Since, purchase of CR-V would involve extra cash outflow of $5,500, Lee Anna should retain LeBaron if all the associated benefits/costs (other than restoration costs) provided by both the cars are same. However, if the utility/value provided by LeBaron doesn't match the expectations of Lee Anna in terms of performance/usage, Lee Anna should purchase CR-V. Also, repair expenses (on recurring basis) associated with LeBaron may deter Lee Anna from proceeding with LeBaron.

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