Mississippi Delta, Inc. has been selling switching equipment to computer compani
ID: 2730921 • Letter: M
Question
Mississippi Delta, Inc. has been selling switching equipment to computer companies on net-30 terms, in which payment is expected by 30 days from the invoice date. Concerned about deteriorating collection patterns, the credit manager has divided customers into two groups for examination purposes:
Prompt payors and laggards. Prompt payors (80 percent of Mississippi Delta’s customers) pay, on average, in 35 days, versus a 72-day average for the laggards. The manager wonders if the credit terms should be modified to include a 2 percent cash discount on invoices paid within 10 days. The average invoice is the same for both groups, roughly $4,000. The manager expects 50% of the prompt payors to pay in exactly 10 days and the average on the other half to slip to 40 days. He thinks that 20% of the laggards will pay in 10 days and the average on the others will slip to 80 days. Given these forecasts, he is not sure that the lost revenue from discount takes (who would then pay only 98% of the invoiced dollar amount) justifies the improved collection. The company’s annual cost of capital is 11%.
A.) Using NPV calculations, show the PV of the present collection experience. B.) Calculate the NPV of the proposed 2/10, net-30 terms. C.) Based on your NPV analysis, should Mississipi Delta Inc. adopt the cash discount? D.) What other factors should be taken into account before Mississippi Delta Inc. makes a switch, assuming such is justifiable on an NPV basis? E.) Sensivity analysis involves varying the key assumptions, one at a time, and observing the effect on the key decision criterion-such as profits or NPV. In the NPV analysis above, how could could one carry out sensitivity analysis? (If you have a financial spreadsheet available, conduct a sensitivity analysis that varies the number of prompt payors who will pay in exactly 10 days and report your findings.)
Answer in an Excel document and give explanation as to how and why you got to your answer
Explanation / Answer
Ans;
DATA FOR CURRENT TERMS:
prompt payors laggards
percent of total customers 80% percent of total customers 20%
average payment day 35 average payment day 72
average invoice amount $4,000 average invoice amount $4,000
annual cost of capital 11.00%
a.) Cash flow timeline under current terms.
Day 0 Avg Prompt Payor Day = 35 Avg Laggard Day = 72
---|-----------------------------------------|------------------------------|----------->
Avg Invoice = (0.8)($4K) Avg Invoice = (0.2)( $4K)
$3,200 $800
PV = $3,200 x 1 / [1 + (0 .11/365) x 35] |
= $3,166.60 <---------------------| |
|
|
PV = $800 x 1 / [1 + (0.11/365) x 72] |
= $783.01 <-------------------------------------------------------|
Total PV of Current Terms = $3,166.60 + $783.01 = $3,949.61
b.) Cashflow timeline under proposed 2/10, net 30 terms
DATA FOR PROPOSED TERMS:
prompt payors laggards
percent of total customers 80.00% percent of total customers 20.00%
payment day, discounting 10 payment day, non discounting 70
payment day, non discounting 40 average invoice amount $4,000
average invoice amount $4,000 percent discount 2.00%
percent discount 2.00% percent to take discount 20.00%
percent to take discount 50.00% annual cost of capital 11.00%
Day 0 Day 10 Day 40 Day 70
--|---------------------------------|-------------------------|-------------------------|--------->
40% x 0.98 x $4K / day 40% x $4K / day 16% x $4K / day
+ 4% x .98 x $4K / day $1,600.00 $640.00
$1,724.80 | |
| | |
PV = $1,719.62{ 1 / [1 + ( .11/365)(10)]} | |
PV $1,719.62 <-----------| | |
| |
| |
PV = $1,600{ 1 / [1 + (.11/365)(40)]} | |
PV $1,580.94 <------------------------------------| |
|
FV = $640 |
PV = $640{ 1 / [1 + (.11/365)(70)]} |
PV $626.78 <------------------------------------------------------------------|
---------------
Total PV of Proposed Terms =
$1,719.62 + $1,580.94 + $626.78
= $3,927.34 per day
c.) Net Present Value of Proposal = $3,925.49 - $3,949.61 = ($22.27)
d.) he other factors that are to be considered are:
Default risk: As the average days in which the laggards (those not availing discount) are making the payment has risen to 70, it increases the default risk. Higher the collection period, higher the default risk.
The credit terms given to the company from its suppliers. If the company also gets a discount from its suppliers for making an early payment, then it is beneficial for the company to imply a cash discount policy.
The competitor and the market, the industry in which the company is has certain general credit policies. The company should also follow that. It should take advantage of the industry policies.
The bargaining power of buyers and suppliers decides the price and credit terms. If the company has a good bargaining power, then it can design credit policy according to it requirement and will. However, if the buyers have good bargaining power, the credit policy will have to be designed otherwise.
e.) By varying the percentage of discount takers, we can observe the change in NPV of the
proposed change. The analysis is valuable in this case, showing that even with no cash
discount takers, the proposal is a loser. In other words, there is no "prompt payor" cash
discount utilization rate which would make this project a winner on an NPV basis.
Here are the sensitivity analysis results:
% Cash Discount
Takers (Prompt Payors) NPV per average invoice
------------------------ -----------------
0% $ (6.46)
30% $ (17.05)
40% $ (20.59)
base case==> 50% $ (24.12)
60% $ (27.65)
70% $ (31.18)