Question

Dickson City Company has annual sales of $5 million, while the cost of goods sold is $3.2 million. All sales are made on a cash basis. The owner of Dickson has come up with the plan of giving credit to the customers. He believes that this will increase the sales by 25% without increasing any of the fixed costs. He thinks that 20% of the customers will pay within 30 days, 40% within 60 days, 37% within 90 days, and 3% of the customers will default on the sales. The cost of capital to Dickson is 12%.

(A) Should Dickson City introduce the policy of credit sales?

Answers: NPV(cash) = $1.8 million, NPV(credit) = 1.941 million, yes. ♥

(B) The manager of the firm doubts whether the sales will actually increase by 25% as a result of this strategy. Find the minimum increase in sales to justify introduction of the new credit policy.

Answer: 15.29%

Answer 1

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Answer:

1.

Calculation of NPV of cash sales:-

Annual sales is $5 million

Cost of goods sold is $3.2 million

Net Present Value=Present value of cash flows−Initial investment=$5 million−3.2 million=$1.8 million

Therefore, the NPV of cash sales is $1.8 million.

Calculation of NPV of credit sales:-

Annual sales=Cash sales×(1+increase)=$5 million×(1 + 25\% )=$6.25 million

a. 20% customer pay in 30 day:-

Customer pay=$6.25 million×20%=$1.25 million

b. 40% customer pay in 60 day:-

Customer pay=$6.25 million×40%=$2.50 million

c. 37% customer pay in 90 day:-

Customer pay=$6.25 million×37%=$2.31 million

d. 3% customer will default:-

Customer default=$6.25 million×3%=$0.19 million

e. Cost of goods sold:-

Cost of goods sold=$3.2 million×(1+25%)=$4 million

=> 1.25M/(1.12%)^30/365 +2.5M/(1.12%)^60/365 +2.3125M/(1.12%)^90/365​​​​​​​ - 4M

= $1.941Million

Since NPV on credit sales > NPV on cash sales we must introduce the option

2)