Should credit be granted to the following applicant or not? If credit is granted
ID: 2781389 • Letter: S
Question
Should credit be granted to the following applicant or not? If credit is granted, we estimate a 50% chance of being paid in one month, a 30% chance of being paid in two months, and a 20% chance of being paid in three months (with necessary assistance being provided by a collection service).
• Invoice amount for our product: $1000
• Variable costs for satisfying the order: $700
• Credit department expenses during the second and third months if not paid in 1 month: $40/month
• Collection service expenses: 40% of every dollar collected by the service
• Cost of capital for our business: 12%
Explanation / Answer
Invoice amount = $1000
Cost of capital = 12%
If paid within one month
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Variable costs = $700
Collection service expenses = 40% * 1000 * 50% = $200
Total cost = $900
NPV = [50%(1000) / (1 + 12%) 1/12 ] – 900 = -$405
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If paid in 2 months
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Variable costs = $700
Collection service expenses = 40% * 1000 * 30% = $120
Credit department expenses = $40
Total cost = $860
NPV = [30%(1000) / (1 + 12%) 2/12 ] – 860 = -$565.61
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If paid in 3 months
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Variable costs = $700
Collection service expenses = 40% * 1000 * 20% = $80
Credit department expenses = $40*2 = $80
Total cost = $860
NPV = [20%(1000) / (1 + 12%) 3/12 ] – 860 = -$665.59
No, the credit should not be granted as all the NPVs are negative