Question

1a. (NPV of Switching to a credit policy) Your company is evaluating a switch from a cash-only policy to a net 30 policy. The price per unit product is $49, and the variable cost per unit is $20. The company currently sells 100 units per month. Under the proposed policy, the company expects to sell 110 units per month. The company’s cost of capital for this line of business is 2% monthly. Assume that the possibility of nonpayment is small enough to ignore. What is the NPV of switching to a net 30 policy? Should the company switch?

1b. (NPV of Switching to a credit policy) Consider the same situation from the previous question, if the projected increase of sales from 100 units to 110 units is only an estimate, what increase in unit sales is necessary for the company to break even when switching to a net 30 policy.

Answer 1

1a. Unit Price = 49 | VC per unit = 20 | Current Sales in units = 100 | New Sales in units after policy = 110

Current Contribution Margin = (Unit Price - VC per unit)*Number of units

Current Contribution Margin = (49 - 20) * 100 = 2,900

New Contribution after credit policy = (49 - 20) * 110 = 3,190

Increase in Contribution Margin = 3,190 - 2,900 = 290

Cost of capital = 2% per month

Before credit policy, the cash outflow in variable cost was of 20*100 = 2000 and inflow of sales collected was 49*100 = 4900, making them a profit of 2,900.

Now with new credit policy, the cash outflow in variable cost will be 20*110 = 2200 and inflow will be 30 days later of sales collected, 49 * 110 = 5390

Incremental outflow = (2200 - 2000) + (4900) = 5100 ((2200 - 2000) is the extra VC spend + 4900 is the cashflow they are missing out at t = 0)

Incremental inflow after 30 days = 5390

NPV = PV of Incremental inflow - Incremental outflow

PV of Incremental inflow = 5390 / (1+2%) = 5,284.31

NPV = 5,284.31 - 5,100 = 184.3

If we take this NPV and use this as perpetual inflow every month, 184.31 / 2% = 9,215.50 is the benefit that the company will get.

Yes, company should switch to the new credit policy as it will be profitable for the company.

1b. For break-even, NPV should be 0.

Therefore, PV of Incremental Inflow and Incremental outflow should be equal.

=> 0 = PV of Incremental inflow - Incremental outflow

PV of Incremental inflow = Incremental outflow

As calculated in the previous part, we will use same calculations except number of units will be n.

Increment outflow = (20n - 2000) + 4900 = 20n + 2900 (The extra VC spent + missed out inflow without policy at t=0)

Incremental inflow = Price per unit * n = 49n (Increased sales inflow after 30 days)

PV of Incremental inflow = 49n / (1+2%)

=> 49n / (1+2%) = 20n + 2900

=> 49n = 20.4n + 2958

=> 28.6n = 2958

=> n = 2958 / 28.6 = 103.43

Sales increase to break-even = 103.43 - 100 = 3.43

Hence, 3.43 units is the break-even units for switching to new credit policy.