Question

A company is considering switching from a cash only policy to a net 30 credit policy. The price per unit is $750 and the variable cost per unit is $650. The company currently sells 1,900 units per month. Under the proposed policy the company expects to sell 2,000 units per month. The required monthly return is .5%. If you were using NPV analysis to decide whether the company should switch to the net 30 credit policy, what amount would you use for the present value of the future incremental cash flows

Answer 1

Net Incremental Cash Flow from Switching to Credit Policy = Increased Quantity * Contribution Margin per Unit

Increased Quantity = New Quantity - Old Quantity = 2000 - 1900 = 100

Contribution Margin per Unit = Price per unit - Variable Cost per Unit = 750 - 650 = 100

Net Incremental Cash Flow from Switching to Credit Policy = 100*100 = 10,000

Present Value of Net Incremental Cash Flow from Switching to Credit Policy

= Cash Flow /  required monthly return = 10,000 / 0.5% = 2000,000

Now Cost of Switching = Loss of Current Revenue for 30 Days + Cost of Incremental Sales

   = Old Quantity * Sales Price + Increased Quantity * Variable Cost

= 1900 * 750 + 100 * 650

= 1490,000

So NPV = Present Value of Net Incremental Cash Flow from Switching to Credit Policy -  Cost of Switching

= 2000,000 - 1490,000

= 510,000

present value of the future incremental cash flows = 2000,000

NPV =510,000

Since NPV > 0 we should accept the project