Question

In: Finance

Evaluating Credit Policy [L02] Air Spares is a wholesaler that stocks engine components and test equipment...

Evaluating Credit Policy [L02] 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 increase 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 every 200 such orders is never collected. The required return is 1.8 percent per period.

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

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

Suppose that customer who don’t default 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?

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

Solutions

Expert Solution

a.       The cash outlay for the credit decision is the variable cost of the engine. If this is a one-time order, the cash inflow is the present value of the sales price of the engine times one minus the default probability. So, the NPV per unit is:

NPV = –$1,600,000 + (1 – .005)($1,725,000)/1.018

NPV = $86,026.52 per unit

The company should fill the order.

b.      To find the breakeven probability of default, p, we simply use the NPV equation from part a, set it equal to zero, and solve for p. Doing so, we get:

NPV = 0 = –$1,600,000 + (1 –p) ($1,725,000)/1.018

p = .0558 or 5.58%

We would not accept the order if the default probability was higher than 5.58 percent.

c.       If the customer will become a repeat customer, the cash inflow changes. The cash inflow is now one minus the default probability, times the sales price minus the variable cost. We need to use the sales price minus the variable cost since we will have to build another engine for the customer in one period. Additionally, this cash inflow is now a perpetuity, so the NPV under these assumptions is:

NPV = –$1,600,000 + (1 – .005)($1,725,000 – 1,600,000)/.018

NPV = $5,309,722.22 per unit

The company should fill the order. The breakeven default probability under these assumptions is:

NPV = 0 = –$1,600,000 + (1 – p)($1,725,000 – 1,600,000)/.018

p = .7696 or 76.96%

We would not accept the order if the default probability was higher than 76.96 percent. This default probability is much higher than in part b because the customer may become a repeat customer.

d.      It is assumed that if a person has paid his or her bills in the past, they will pay their bills in the future. This implies that if someone doesn’t default when credit is first granted, then they will be a good customer far into the future, and the possible gains from the future business outweigh the possible losses from granting credit the first time.


Related Solutions

Air Spares is a wholesaler that stocks engine components and test equipment for the commercial aircraft...
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 increase fuel economy. The variable cost is $2.5 million per unit and the credit price is $2.815 million each. Credit is extended for one period and based on historical experience, payment for about 1 out of every 100 such orders is never collected. The required return is 3.1 percent per...
Air Spares is a wholesaler that stocks engine components and test equipment for the commercial aircraft...
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...
Air spaces is a wholesaler that stocks engine components and test equipment for the commercial aircraft...
Air spaces 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 by bass turbine engines, which increase fuel economy. The variable cost is $2.6million per unit, and the credit price is $2.815 million each. Credit is extended for one period, and based on historical experience, payment for about 1 out of every 200 such orders is never collected. The required return is 2.9 per...
. What are the components of a firm’s credit policy, and why are they important?
. What are the components of a firm’s credit policy, and why are they important?
A car manufacturer wants to test a new engine to determine whether it meets new air...
A car manufacturer wants to test a new engine to determine whether it meets new air pollution standard (true mean emission must be less than 20 parts per million of carbon). Ten engines manufactured for testing purposes yield the following emission levels: 15.9, 16.2, 21.5, 19.5, 16.4, 18.4, 19.8, 17.8, 12.7, 14.8 Assume that the normal distribution assumption is satisfied for this sample. Do the data supply sufficient evidence to allow the manufacturer to conclude that this type of engine...
1a. (NPV of Switching to a credit policy) Your company is evaluating a switch from a...
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...
Kennedy Air is evaluating a new project.  The equipment will cost $50,000 plus $10,000 to install.  It will...
Kennedy Air is evaluating a new project.  The equipment will cost $50,000 plus $10,000 to install.  It will be depreciated using the MACRS 3-year class.  The project would require an increase in inventories of $6,000 and an increase in A/P of $1,000.  The firm’s yearly revenues would increase by $40,000 but would also increase operating costs by $10,000.  The project is expected to last 3 years and the equipment can then be sold for $10,000.  The firm’s tax rate is 40% and their cost of capital...
Kennedy Air is evaluating a new project. The equipment will cost $70,000 plus $8,000 to install....
Kennedy Air is evaluating a new project. The equipment will cost $70,000 plus $8,000 to install. It will be depreciated using the MACRS 3-year class. The project would require an increase in inventories of $5,000 and an increase in A/P of $3,000. The firm’s yearly revenues would increase by $70,000 but would also increase operating costs by $20,000. The project is expected to last 3 years and the equipment can then be sold for $12,000. The firm’s tax rate is...
Describe the incremental analysis approach for evaluating a proposed credit policy change. How can risk be...
Describe the incremental analysis approach for evaluating a proposed credit policy change. How can risk be incorporated into the analysis? As a general rule, is it more likely that a company would increase its profitability if it tightened or loosened its credit policy? Explain.
A major car manufacturer wants to test a new engine to determine whether it meets new air pollution standards.
A major car manufacturer wants to test a new engine to determine whether it meets new air pollution standards. The mean emission of all engines of this type must be lower than 20 parts per million of carbon. A number of engines are manufactured for testing purposes, and the emission level of each is determined. The data (in parts per million) are listed below:15.6, 16.2, 22.5, 20.5, 16.4, 19.4, 16.6, 17.9, 12.7, 13.9a). At 5% level of significance, is there...
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT