In: Finance
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.
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.