Chapter 05_2 - Credit and Inventory Management

CHAPTER 5_2 CREDIT AND INVENTORY MANAGEMENT

1. a. There are 30 days until account is overdue. If you take the full period, you must remit:

Remittance = 350($140)
Remittance = $49,000

b. There is a 1 percent discount offered, with a 10-day discount period. If you take the discount,
you will only have to remit:

Remittance = (1 – .01)($49,000)
Remittance = $48,510

c. The implicit interest is the difference between the two remittance amounts, or:

Implicit interest = $49,000 – 48,510

Implicit interest = $490

The number of days’ credit offered is:

Days’ credit = 30 – 10
Days’ credit = 20 days

2. The receivables turnover is:

Receivables turnover = 365/Average collection period

Receivables turnover = 365/34
Receivables turnover = 10.735 times

And the average receivables are:

Average receivables = Sales/Receivables turnover

Average receivables = $38,000,000 / 10.735
Average receivables = $3,539,726

3. a. The average collection period is the percentage of accounts taking the discount times the
discount period, plus the percentage of accounts not taking the discount times the days until
full payment is required, so:

Average collection period = .65(10 days) + .35(30 days)

Average collection period = 17 days

b. And the average daily balance is:

Average balance = 1,300($1,750)(17)(12/365)

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Average balance = $1,271,506.85

4. The daily sales are:

Daily sales = $17,300 / 7

Daily sales = $2,471.43

Since the average collection period is 36 days, the average accounts receivable is:

Average accounts receivable = $2,471.43(36)

Average accounts receivable = $88,971.43

5. The interest rate for the term of the discount is:

Interest rate = .01/.99

Interest rate = .0101, or 1.01%

And the interest is for:

30 – 10 = 20 days

So, using the EAR equation, the effective annual interest rate is:

EAR = (1 + Periodic rate)m – 1

EAR = (1.0101)365/20 – 1
EAR = .2013 or 20.13%

a. The periodic interest rate is:

Interest rate = .02/.98

Interest rate = .0204 or 2.04%

And the EAR is:

EAR = (1.0204)365/20 – 1
EAR = .4459 or 44.59%

b. The EAR is:

EAR = (1.0101)365/35 – 1
EAR = .1105 or = 11.05%

c. The EAR is:

EAR = (1.0101)365/16 – 1
EAR = .2577 or 25.77%

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6. The receivables turnover is:

Receivables turnover = 365/Average collection period

Receivables turnover = 365/33
Receivables turnover = 11.0606 times

And the annual credit sales are:

Annual credit sales = Receivables turnover × Average daily receivables

Annual credit sales = 11.0606($42,300)
Annual credit sales = $467,863.64

7. The total sales of the firm are equal to the total credit sales since all sales are on credit, so:

Total credit sales = 8,200($430)

Total credit sales = $3,526,000

The average collection period is the percentage of accounts taking the discount times the
discount period, plus the percentage of accounts not taking the discount times the days until full
payment is required, so:
Average collection period = .60(10) + .40(40)
Average collection period = 22 days

The receivables turnover is 365 divided by the average collection period, so:

Receivables turnover = 365/22

Receivables turnover = 16.591 times

And the average receivables are the credit sales divided by the receivables turnover so:

Average receivables = $3,526,000/16.591

Average receivables = $212,526.03

If the firm increases the cash discount, more people will pay sooner, thus lowering the average
collection period. If the ACP declines, the receivables turnover increases, which will lead to a
decrease in the average receivables.
8. The average collection period is the net credit terms plus the days overdue, so:

Average collection period = 30 + 7

Average collection period = 37 days

The receivables turnover is 365 divided by the average collection period, so:

Receivables turnover = 365/37

Receivables turnover = 9.8649 times

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And the average receivables are the credit sales divided by the receivables turnover so:

Average receivables = $9,300,000 / 9.8649

Average receivables = $942,739.73

9. 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 price of the engine times one minus
the default probability. So, the NPV per unit is:

NPV = –$1,900,000 + (1 – .005)($2,015,000)/1.018

NPV = $69,474.46 per unit

The company should fill the order.

b. To find the break-even probability of default, , we simply use the NPV equation from part a,
set it equal to zero, and solve for . Doing so, we get:

NPV = 0 = –$1,900,000 + (1 – )($2,015,000)/1.018

 = .0401, or 4.01%

We would not accept the order if the default probability was higher than 4.01 percent.

c. If the customer will become a repeat customer, the cash inflow changes. The cash inflow is
now one minus the default probability, times the sales price minus the variable cost. We need
to use the 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 = –$1,900,000 + (1 – .005)($2,015,000 – 1,900,000)/.018

NPV = $4,456,944.44 per unit

The company should fill the order. The break-even default probability under these
assumptions is:

NPV = 0 = –$1,900,000 + (1 – )($2,015,000 – 1,900,000)/.018

 = .7026, or 70.26%

We would not accept the order if the default probability was higher than 70.26 percent. This
default probability is much higher than the default probability 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, they will pay their 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 granting credit the first time.
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10. 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 = $720(1,240) + $525(1,290 – 1,240)

Cost of switching = $919,050

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

Benefit of switching = ($720 – 525)(1,290 – 1,240)

Benefit of switching = $9,750

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

NPV = –$919,050 + $9,750/.0095

NPV = $107,265.79

The firm will have to bear the cost of 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 new sales offsetting one
another.

11. The carrying costs are the average inventory times the cost of carrying an individual unit, so:

Carrying costs = (2,500/2)($7.50) = $9,375

The order costs are the number of orders times the cost of an order, so:
Order costs = (52)($1,300) = $67,600

The economic order quantity is:

EOQ = [(2T × F)/CC]1/2

EOQ = [2(52)(2,500)($1,300)/$7.50]1/2
EOQ = 6,713.17

The firm’s policy is not optimal, since the carrying costs and the order costs are not equal. The
company should increase the order size and decrease the number of orders.

12. The carrying costs are the average inventory times the cost of carrying an individual unit, so:

Carrying costs = (300/2)($38) = $5,700

The order costs are the number of orders times the cost of an order, so:

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Restocking costs = 52($75) = $3,900

The economic order quantity is:

EOQ = [(2T × F)/CC]1/2

EOQ = [2(52)(300)($75)/$38]1/2
EOQ = 248.15

The number of orders per year will be the total units sold per year divided by the EOQ, so:

Number of orders per year = 52(300)/248.15

Number of orders per year = 62.86

The firm’s policy is not optimal, since the carrying costs and the order costs are not equal. The
company should decrease the order size and increase the number of orders.

Intermediate

13. The total carrying costs are:

Carrying costs = (Q/2)  CC

where CC is the carrying cost per unit. The restocking costs are:

Restocking costs = F  (T/Q)

Setting these equations equal to each other and solving for Q, we find:

CC  (Q/2) = F  (T/Q)
Q2 = 2  F  T /CC
Q = [2F  T /CC]1/2 = EOQ

14. The cash flow from either policy is:

Cash flow = (P – v)Q

So, the cash flows from the old policy are:

Cash flow from old policy = ($86 – 47)(3,510)

Cash flow from old policy = $136,890

And the cash flow from the new policy would be:

Cash flow from new policy = ($88 – 47)(3,620)

Cash flow from new policy = $148,420
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So, the incremental cash flow would be:

Incremental cash flow = $148,420 – 136,890

Incremental cash flow = $11,530

The incremental cash flow is a perpetuity. The cost of initiating the new policy is:

Cost of new policy = –[PQ + v(Q – Q)]

So, the NPV of the decision to change credit policies is:

NPV = –[($86)(3,510) + ($47)(3,620 – 3,510)] + $11,530/.025

NPV = $154,170

15. The cash flow from the old policy is:

Cash flow from old policy = ($150 – 130)(1,550)

Cash flow from old policy = $31,000

And the cash flow from the new policy will be:

Cash flow from new policy = ($154 – 133)(1,580)

Cash flow from new policy = $33,180

The incremental cash flow, which is a perpetuity, is the difference between the old policy cash
flows and the new policy cash flows, so:

Incremental cash flow = $33,180 – 31,000

Incremental cash flow = $2,180

The cost of switching credit policies is:

Cost of new policy = –[PQ + Q(v – v) + v(Q – Q)]

In this cost equation, we need to account for the increased variable cost for all units produced.
This includes the units we already sell, plus the increased variable costs for the incremental units.
So, the NPV of switching credit policies is:

NPV = –[($150)(1,550) + (1,550)($133 – 130) + ($133)(1,580 – 1,550)] + ($2,180/.0095)

NPV = –$11,666.32
16. If the cost of subscribing to the credit agency is less than the savings from collection of the bad
debts, the company should subscribe. The cost of the subscription is:

Cost of the subscription = $750 + $6(500)

Cost of the subscription = $3,750

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And the savings from having no bad debts will be:

Savings from not selling to bad credit risks = ($390)(500)(0.04)

Savings from not selling to bad credit risks = $7,800

So, the company’s net savings will be:

Net savings = $7,800 – 3,750

Net savings = $4,050

The company should subscribe to the credit agency.

Challenge

17. The cost of switching credit policies is:

Cost of new policy = –[PQ + Q(v – v) + v(Q – Q)]

And the cash flow from switching, which is a perpetuity, is:

Cash flow from new policy = [Q(P – v) – Q(P – v)]

To find the break-even quantity sold for switching credit policies, we set the NPV equal to zero
and solve for Q. Doing so, we find:

NPV = 0 = –[($86)(3,510) + ($47)(Q – 3,510)] + [(Q)($88 – 47) – (3,510)($86 – 47)]/.025

0 = –$301,860 – $47Q + $164,970 + $1,640Q – $5,475,600
$1,593Q = $5,612,490
Q = 3,523.22

18. We can use the equation for the NPV we constructed in Problem 17. Using the sales figure of
3,750 units and solving for P, we get:

NPV = 0 = [–($86)(3,510) – ($47)(3,750 – 3,510)] + [(P – 47)(3,750) – ($86 – 47)(3,510)]/.025

0 = –$301,860 – 11,280 + $150,000P – 7,050,000 – 5,475,600
$150,000P = $12,838,740
P = $85.59
19. From Problem 15, the incremental cash flow from the new credit policy will be:

Incremental cash flow = Q(P – v) – Q(P – v)

And the cost of the new policy is:

Cost of new policy = –[PQ + Q(v – v) + v(Q – Q)]

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Setting the NPV equal to zero and solving for P, we get:

NPV = 0 = –[($150)(1,550) + ($133 – 130)(1,550) + ($133)(1,580 – 1,550)] + [(1,580)(P – 133) –

(1,550)($150 – 130)]/.0095
0 = –[$232,500 + 4,650 + 3,990] + $166,315.79P – 22,120,000 – 3,263,157.90
$166,315.79P = $25,624,297.90
P = $154.07

20. Since the company sells 700 suits per week, and there are 52 weeks per year, the total number
of suits sold is:

Total suits sold = 700 × 52 = 36,400

And, the EOQ is 500 suits, so the number of orders per year is:

Orders per year = 36,400 / 500 = 72.80

To determine the day when the next order is placed, we need to determine when the last order
was placed. Since the suits arrived on Monday and there is a three-day delay from the time the
order was placed until the suits arrive, the last order was placed Friday. Since there are
approximately five days between the orders, the next order will be placed on Wednesday

Alternatively, we could consider that the store sells 100 suits per day (700 per week / 7 days).
This implies that the store will be at the safety stock of 100 suits on Saturday when it opens.
Since the suits must arrive before the store opens on Saturday, they should be ordered three
days prior to account for the delivery time, which again means the suits should be ordered on
Wednesday.

21. The cash outlay for the credit decision is the variable cost of the engine. Since the orders can be
one-time or perpetual, the NPV of the decision is the weighted average of the two potential sales
streams. The initial cost is the cost for all of the engines. So, the NPV is:

NPV = –$1,425,000 + (1 – .30)(125)($13,000)/1.019 + .30(125)($13,000 – 11,400)/.019

NPV = $2,849,185.22

The company should fill the order.

22. The default rate will affect the value of the one-time sales as well as the perpetual sales. All
future cash flows need to be adjusted by the default rate. So, the NPV now is:

NPV = –$1,425,000 + (1 – .15)[(1 – .30)(125)($13,000)/1.019 + .30(125)($13,000 – 11,400)/.019]

NPV = $2,208,057.44

The company should still fill the order.

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23. The cash flow from the old policy is the quantity sold times the price, so:

Cash flow from old policy = 25,000($450)

Cash flow from old policy = $11,250,000

The cash flow from the new policy is the quantity sold times the new price, all times one minus
the default rate, so:

Cash flow from new policy = 25,000($472)(1 – .03)

Cash flow from new policy = $11,446,000

The incremental cash flow is the difference in the two cash flows, so:

Incremental cash flow = $11,446,000 – 11,250,000

Incremental cash flow = $196,000

The cash flows from the new policy are a perpetuity. The cost is the old cash flow, so the NPV of
the decision to switch is:

NPV = –$11,250,000 + $196,000/.025

NPV = –$3,410,000

24. a. The old price as a percentage of the new price is:

$99/$100 = .99

So the discount is:

Discount = 1 – .99 = .01, or 1%

The credit terms will be:

Credit terms: 1/20, net 30

b. We are unable to determine for certain since no information is given concerning the
percentage of customers who will take the discount. However, the maximum receivables
would occur if all customers took the credit, so:
Receivables = 2,400($100)
Receivables = $240,000 (at a maximum)

c. Since the quantity sold does not change, variable cost is the same under either plan.
d. No, because:

d –  = .01 – .08
d –  = –.07, or –7%

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Therefore the NPV will be negative. The NPV is:

NPV = –2,400($99) + (2,400)($100)(.01 – .08)/(.01)

NPV = –$2,477,600

The break-even credit price is:

P(1 + r)/(1 – ) = $99(1.01)/(.92)

P = $108.42

This implies that the break-even discount is:

Break-even discount = 1 – ($99/$108.42)

Break-even discount = .0868 or 8.68%

The NPV at this discount rate is:

NPV = –2,400($99) + (2,400)($108.42)(.0868 – .08)/(.01)

NPV  0

25. a. The cost of the credit policy switch is the quantity sold times the variable cost. The cash
inflow is the price times the quantity sold, times one minus the default rate. This is a one-time, lump
sum, so we need to discount this value one period. Doing so, we find the NPV is:

NPV = –15($540) + (1 – .2)(15)($975)/1.02 = $3,370.59

The order should be taken since the NPV is positive.

b. To find the break-even default rate, , we just need to set the NPV equal to zero and solve
for the break-even default rate. Doing so, we get:
NPV = 0 = –15($540) + (1 – )(15)($975)/1.02
 = .4351, or 43.51%

c. Effectively, the cash discount is:

Cash discount = ($975 – 910)/$975

Cash discount = .0667, or 6.67%

Since the discount rate is less than the default rate, credit should not be granted. The firm
would be better off taking the $910 up-front than taking an 80% chance of making $975.

26. a. The cash discount is:

Cash discount = ($69 – 64)/$69 = .0725, or 7.25%

The default probability is one minus the probability of payment, or:

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Default probability = 1 – .90 = .10

Since the default probability is greater than the cash discount, credit should not be granted;
the NPV of doing so is negative.

b. Due to the increase in both quantity sold and credit price when credit is granted, an additional
incremental cost is incurred of:

Additional cost = (5,800)($33 – 32) + (6,400 – 5,800)($33)

Additional cost = $25,600

The break-even price under these assumptions is:

NPV = 0 = –$25,600 – (5,800)($64) + {6,400[(1 – .10)P – $33] – 5,800($64 – 32)}/(1.00753 – 1)

NPV = –$25,600 – 371,200 + 254,089.56P – 9,316,617.35 – 8,187,330.40
 $17,900,747.75 = $254,089.56P
P = $70.45

c. The credit report is an additional cost, so we have to include it in our analysis. The NPV
when using the credit reports is:

NPV = 5,800(32) – .90(6,400)33 – 5,800(64) – 6,400($1.50) + {6,400[0.90(69 – 33) – 1.50] –

5,800(64 – 32)} / (1.00753 – 1)
NPV = $151,131.30

The reports should be purchased and credit should be granted.

27. We can express the old cash flow as:

Old cash flow = (P – v)Q

And the new cash flow will be:

New cash flow = (P – v)(1 – )Q + Q [(1 – )P – v]

So, the incremental cash flow is:

Incremental cash flow = –(P – v)Q + (P – v)(1 – )Q + Q [(1 – )P – v]
Incremental cash flow = (P – v)(Q – Q) + Q [(1 – )P – P]

Thus:
 (P - v)(Q - Q) + Q{(1 -  )P  - P}
NPV = (P – v)(Q – Q) – PQ +  
 R 

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