Question

A firm currently sells its product with a 2% discount to customers who pay by cash or credit card when they purchase one of the firm's products; otherwise, the full price is due within 30 days. Forty percent (40%) of customers take advantage of the discount. The firm plans to drop the discount so the new terms will simply be net 30. In doing so it expects to sell 100 fewer units per month and all customers to pay at day 30. The firm currently sells 1,000 units per month at a cost per unit of $40 and a selling price per unit of $80. If the firm's required return is 2%, what is the net present value (NPV) of making this change? (Assume that all 1,000 units are sold at the beginning of the month and the cost of producing the units is paid immediately.)

Answer 1

On considering the new idea of the company the total expected sales will 1000 - 100 = 900, as it is mentioned in the question that due to dropping the plan of discount 100 units will be reduced from what it has been actually.

Here we are required to calculated Net Present Value (NPV) of the new plan.

NPV = Cash inflow before depreciation after Tax - Cash outflow.

Here we need to know the revenue generated from the sales. i.e., 900 * 80 = 72,000

the total cost of producing 900 units will be 900 * 40 = 36,000.

profit generated from the sale of goods = 72000 - 36000 = 36,000

hence no information about depreciation or tax is not mentioned we take 36,000 as cash inflow from the new project.

by using the discount rate of 2% = 36000 * .9804 = 35294.4

the above provide value will be the npv of new idea.

Now lets find out what will be the value of the present practice.

total sales = 1000 * 80 = 80,000

expenses = 1000 * 40 = 40,000

revenue = 80,000 - 40,000 = 40,000

discount of 2% on 40% of the total revenue. = hence it is provided that 40% of the customers avail this facility it will get reduce from the receivable revenue. hence, 80 * .02 = $1.6 will be provided as discount.

if total sales is 1000 unit 40% of 1000 units will be = 400 units

hence for this 400 units the company will allow a discount of 1.6 from its revenue

therefore 400 * 80 = 32,000 - 640 ( 400 * 1.6) viz., 31,360.

by adding revenue from 400 unit to 600 unit it will be = 79,360.

cash from of present sale then will be 79,360 - 40,000. = 39,360

There can be a loss of (39,360 - 35294.4) 4065.6 by adopting a new method of sales. Providing a discount can increase sales and this effect will increase the net profit to the company even if that takes off a portion of the profit.

Hence the NPV of the new project has a - 4066 value.