Question

Air Spares is a wholesaler that stocks engine components and test equipment for the commercial aircraft industry. A new customer has placed an order for eight high-bypass turbine engines, which is fuel economy. The variable cost is 1.6 million per unit, and the credit price is 1.725 million each. Credit is extended for one period, and based on historical experience, payment for about 1 out of 200 such orders is never collected. The required rate of return is 1.8 percent per period.

a) Assuming that this is a one time order, should it be filled? The customer will not but if credit is not extended.

b) What is the break even probability of default in part (a)?

c) Suppose that customers who don't fault become repeat customers and place the same order every period forever. Further assume that repeat customers never default. Should the order be filled? What is the break-even probability of default?

d) Describe in general terms why credit terms will be more liberal when repeat orders are a possibility.

Answer 1

a) NPV is used to find out whether the order should be filled or not.

Cash outflow= variable cost = 1.6 mn*8= 12.8 mn

Cash inflow= 1.725*8= 13.8 mn

1 out of 200 may default= default probability= 1/200= 0.005

Rate of return= 0.018

Cash inflow is after 1 year

NPV= -12.8 + 13.8*(1-0.005)/ (1+0.018)

= 0.688

Since NPV is positive, the order should be fulfilled

b) For break-even probability of default (x), take NPV=0

0= -12.80+ (1-x)* 13.8/ (1.018)

x= 0.05577= ~5.58%

Default upto 5.58% can be accepted

C) Every year same order is placed, meaning perpetuity

PV for perpetuity= D/r

D= cash inflow

r= rate of return

Since, every year there is order, every year the variable cost for making the order incurs.

Credit period = 1 year

Therefore, NPV= -12.8+ (13.8-12.8)/0.018 (since, on day 0, only cash outflow happens)

= ~42.755

Therefore the order should be fulfilled

For break-even probability of default, NPV=0

0= -12.8+ (((1-x)*13.8)-12.8)/0.018

x=0.05577= 5.58%

Default upto 5.58% is acceptable