The following should be used to solve each query. ABC Inc. is a small manufactur
ID: 2813997 • Letter: T
Question
The following should be used to solve each query.
ABC Inc. is a small manufacturing company. Currently, ABC extends credit to its customers on a net 45 basis, but the company is having an issue with collecting payments in a timely manner. Currently, ABC's customers pay 90 days (n=90) after being invoiced. ABC is currently contemplating giving customers a 5% discount if they pay within 20 days of the invoice date. Currently, the average invoice amount is $12,000, but the company believes that the average invoice will grow to $12,300 if it provides a 5% discount. Futhermore, ABC believes that 60% of its customers will pay in exactly 20 days (DSO=20) if the discount is introduced, while the remaining 40% will continue to pay 90 days after being invoiced. ABC's annual cost of capital is 15%.
1. What is the current present value of the average invoiced received by the corporation (ignoring the potential discount)? Round intermediate steps to four decimals.
2. Does it make financial sense for ABC to pursue the 5% discount policy? Round intermediate steps to four decimals.
Explanation / Answer
Soln : Step 1 : We need to calculate how much amount is to be paid by the customers to ABC after 90 days in current scenario, as ABC is extending the credit at 45 basis point. (net means we consider 1.0045 and t = 1)
Current invoice value = 12000, Customers to pay = 12000*(1+ 0.45%) = 12054
Current present value of average invoice, PV = 12054/(1+r)t
Here, t = 90 days = 90/360 = 0.25 years, r = cost of capital for ABC = 15%
PV = 12054/(1.15)0.25 = $11640.1004
Current present value of average invoice = $11640.1004
b) Now, let's take the case when discount is offered.
60% public is paying in 20 days i.e amount collected in 20 days = 12300*60%*0.95 = 7011
5% discount considered above
40% paying after 90 days i.e. at 45 basis points net = 40% *12300*1.0045 = 4942.1400
Current present value of the same, New PV = 7011/(1+15%)20/360 + 4942.1400/(1.15)0.25
New PV = 6956.7735 + 4772.4412 = 11729.2147
New PV > current PV, hence it makes financial sense for ABC to pursue the 5% discount policy