Exercise: CH# 6 Credit Granting Decisions

Evaluating Credit Policy:

Problem 1: 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 increases fuel economy. The
variable cost is $ 1.4 million per unit, and the credit price is $1.65 million each.
Credit is extended for one period, and based on historical experience; payment
for about 1 out of 200 such orders is never collected. The required return is 2.5%
per period.

(a) Assuming that this is a one-time order, should it be filled? The customer
will not buy if credit is not extended?
(b) What is the break-even probability of default in part (a)
(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?
(d) Describe in general terms why credit terms will be more liberal when
repeat orders are a possibility?

Answers:

(a) The cash outlay for the credit decision is the variable cost of the engine. If
this is a one-time order, the cash inflow is the present value of the sales rice
times one minus the default probability( π ). So, the NVP per unit is:

NPV =−V +(1−π )P /(1+R )=−$1, 400, 000+(1−. 005)( $1, 650, 000)/1. 025=$201,703, 32

The company should fill the order.

(b) To find the breakeven probability of default, π , we simply use the NPV
equation from part a, set it equal to zero, and solve for π . Doing so, we get:
 NPV =0=−V +(1−π )P/(1+R )=−$ 1 , 400 , 000+(1−. π )( $ 1 , 650 ,000 )/1. 025
π =0 . 1303=13 . 03 %

We should not accept the order if the default probability was higher than
13.03%.

(c) If the customer will become a repeat customer, the cash inflow changes.
The cash inflow is now (1- π ) times the sales price minus the variable cost.
We need to use sales price minus the variable cost since we will have to
build another engine for the customer in one period. Additionally, this cash
inflow is now a perpetuity, so the NPV under these assumptions is:

NPV =−V +(1−π )(P−V )/R=−$1,400 ,000+(1−.005 )($1,650,000−1,400,000)/0 .025

=$8,550 ,000,00

The company should fill the order. The breakeven default probability under
these assumptions is:
NPV =0=−V +(1−π )(P−V )/ R=−$ 1, 400 ,000+(1−. π )($ 1, 650 , 000−1 , 400 , 000 )/0. 025
π =0 . 8600=86. 00 %
We will not accept the order if the default probability was higher than
86.00%. This default probability is much higher than in part (b) because the
customer may become a repeat customer.

(d) It is assumed that if a person has paid his or her bills in the past, he/ she will
pay his/her bills in the future. This implies that if someone doesn’t default
when credit is first granted, then they will be a good customer far into the
future, and the possible gains from the future business outweigh the
possible losses from grating credit first time.

Credit Policy Evaluation

Problem 2: Quest, Inc., is considering a change in its cash-only sales policy. The
new terms of sales would be net one month. Based on the following information,
determine if Quest should proceed or not. Describe the buildup of receivables in
this case. The required return is 1.5% per month.

Current Policy New Policy

Price per unit $780 $780
Cost per unit 475 475
Unit sales per month 1,420 1,505

Answers:

The cost of switching is the lost sales from the existing policy plus the incremental
variable costs under the new policy, so:
'
Cost of switching = PQ+ v (Q −Q)=$ 780 (1 , 420 )+$ 475(1 , 505−1 , 420 )=$ 1, 147 , 975

The benefit of switching is the new sales price minus the variable costs per unit,
times the incremental units sold, so:

'
Benefit of switching = ( P−v )(Q −Q)=( $ 780−475)(1 , 505−1 , 420 )=$ 25 , 925

The benefit of switching is perpetuity, so the NPV of the decision to switch is:

NPV of switching
' '
= −[ PQ+ v (Q −Q)]+[(P−v )(Q −Q)]/ R=−1 ,147 , 975+25 , 925 /0 . 015=$ 580 , 358 .33

The firm will have to bear the cost of the sales for one month before they receive
any revenue from credit sales, which is why the initial cost is for one month.
Receivables will grow over the one month credit period and will then remain
stable with payments and sales offsetting one another.

Credit Policy Evaluation

Problem 3: The XYZ Corporation is considering a change in its cash-only policy.
The items would be net one period. Based on the following information,
determine if XYZ should proceed or not. The required return is 3% per period.

Current Policy New Policy

Price per unit $82 $84
Cost per unit 43 43
Unit sales per month 4,150 4,380

Credit Policy Evaluation

Problem 4: Happy Times currently has an all-cash credit policy. It is considering

making a change in the credit policy by going to terms of sale net 30 days. Based
on the following information, what would you recommend? The required return
is 2% per month.

Current Policy New Policy

Price per unit $330 $334
Cost per unit 260 265
Unit sales per month 1,250 1,310

Credit Policy

Problem 5: The Silver Spokes Bicycle Shop has decided to offer credit to its
customers during the Summer selling season. Sales are expected to be 400
bicycles. The average cost to the shop of a bicycle is $280. The owner knows that
only 97% of the customers will be able to make their payments. To identify the
remaining 3%, the firm is considering subscribing to a credit agency. The initial
charge for this service is $500, with an additional charge of $4 per individual
report. Should the firm subscribe to the agency?