Chapter 28, Problem 9QP

Evaluating Credit Policy Air Spares is a wholesaler that stocks engine components and test equipment for the commercial aircraft industry. A new customer has placed an order for eight high-bypass turbine engines, which increase fuel economy. The variable cost is $2.6 million per unit, and the credit price is $2.815 million each. Credit is extended for one period, and based on historical experience, payment for about 1 out of every 200 such orders is never collected. The required return is 2.9 percent per period.

1. a. Assuming that this is a one-time order, should it be filled'' The customer will not buy if credit is not extended.
2. b. What is the break-even probability of default in part (a)?
3. c. Suppose that customers who don’t default become repeat customers and place the same order every period forever. Further assume that repeat customers never default. Should the order be filled? What is the break-even probability of default?
4. d. Describe in general terms why credit terms will be more liberal when repeat orders are a possibility.

Summary Introduction

To explain: Whether order should be accepted or not.

Credit Policy:

Credit policies are the guidelines of a business for customers. These policies contain the terms and conditions related to credit sales.

Explanation of Solution

Given,

A company’s variable cost is $2.6 million per unit.

Credit price is $2.815 million.

Required return is 2.9%.

Bad debt is 1/200.

The order must be accepted if the net present value is positive, that means inflows are greater than outflows.

Calculate net present value (NPV).

Formula to compute net present value,

$\text{Net Present Value}=\text{Inflow}-\text{Outflow}$

Substitute $2721987.37 for inflow and $2,600,000 for outflow.

$\begin{array}{c}\text{Net Present Value}=\text{\$2,721,987}\text{.37}-\text{\$2,600,000}\\ =\$\text{121,987}\text{.37}\end{array}$

Working note:

Calculation of inflow,

$\begin{array}{c}\text{Inflow}=\frac{\text{Sales}\left(1-\text{Default percentage}\right)}{1+\text{Return percentage}}\\ =\frac{\$2,815,000\left(1-0.005\right)}{1.029}\\ =\$2,721,987.37\end{array}$

Conclusion

Hence, order should be accepted since the NPV is positive.

Summary Introduction

To compute: Break even probability.

Explanation of Solution

Solution:

At break even probability, inflows are equal to outflows that mean net present value is zero.

Formula to calculate breakeven probability,

$\text{Net Present Value}=\frac{\text{Sales}\left(1-\text{Default percentage}\right)}{1+\text{Return percentage}}-\text{Outflow}$

Substitute 0 for net present value, $2,815,000 for sales, 0.029 for return percentage and $2,600,000 for outflow.

$\begin{array}{c}\frac{\text{\$2,815,000}\left(1-\text{Default percentage}\right)}{1+0.\text{029}}-\text{\$2,600,000}=0\\ \text{\$2,815,000}\left(1-\text{Default percentage}\right)=\$2,600,000\left(1+0.\text{029}\right)\\ 1-\text{Default percentage}=\frac{\$2,675,400}{\text{\$2,815,000}}\\ \text{Default percentage}=4.96\%\end{array}$

Conclusion

Hence, break even probability is 4.96%.

Summary Introduction

To compute: Whether order must be accepted or not and break even probability.

Explanation of Solution

Solution:

The order should be accepted if the net present value is positive that means inflows are greater than outflows.

Calculate net present value.

Formula to compute net present value,

$\text{Net present value}=\text{Inflow}-\text{Outflow}$

Substitute $7,376,724.14 for inflow and $2,600,000 for outflow.

$\begin{array}{c}\text{Net present value}=\$7,376,724.14-\$2,600,000\\ =\$4,776,724.14\end{array}$

At break even probability, inflows are equal to outflows that mean net present value is zero.

Formula to calculate breakeven probability,

$\text{Net Present Value}=\frac{\text{Sales}\left(1-\text{Default percentage}\right)}{\text{Return percentage}}-\text{Outflow}$

Substitute 0 for net present value, $215,000 for sales, 0.029 for return percentage and $2,600,000 for outflow.

$\begin{array}{c}\frac{\text{\$215,000}\left(1-\text{Default percentage}\right)}{\text{0}\text{.029}}-\text{\$2,600,000}=0\\ \text{\$215,000}\left(1-\text{Default percentage}\right)=\$75,400\\ 1-\text{Default percentage}=0.3507\\ \text{Default percentage}=64.93\%\end{array}$

Working note:

Calculation of inflow,

$\begin{array}{c}\text{Inflow}=\frac{\text{Sales}\left(1-\text{default percentage}\right)}{\text{Return percentage}}\\ =\frac{\left(\$2,815,000-\$2,600,000\right)\left(1-0.005\right)}{0.029}\\ =\$7,376,724.14\end{array}$

Conclusion

Hence, order should be accepted and break even probability is 64.93%.

Summary Introduction

To explain: Liberty in credit terms.

Answer to Problem 9QP

Solution:

Credit terms will be more liberal when there are repeat orders.

It is believed by the company that once a customer has paid his credit, he will also repay the  future credit sales.

Explanation of Solution

• It is believed that once a good customer, is always a good customer.
• It is believed that if a customer has not defaulted in past, he will not default in future as well.

Conclusion

Hence, credit terms will be more liberal when there are repeating of orders.