Question

The Edward H. & Wael F. (E & W) 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. Sixty percent 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 150 fewer units per month and all customers to pay at day 30. The E&W firm currently sells 1500 units per month at a cost per unit of $45 and a selling price per unit of $80. If the firm’s required return is 3%, what is the net present value (NPV) of making this change? (Show all the steps and your calculations; see the example 19.4).

Answer 1

Let's analyze the cash flows in any 30 days period.

Existing policy: Sale Price = $ 80 per unit

Discount on immediate payment = 2%

Discounted price = $ 80 x (1 - 2%) = $ 78.40

Sale Volume = 1,500 units

Customers taking discount = 60%

Nos. of units sold under discount = 60% x 1,500 = 900

Parameter	Now	30 days
Produce first set of 1500 units per month at a cost per unit of $45	-67,500.00
Customers pay for 900 units @ $78.40 per unit	70,560.00
Customers pay for 600 units @ $80 per unit		48,000.00
Produce next set of 1500 units per month at a cost per unit of $45		-67,500.00
Customers pay for 900 units @ $78.40 per unit		70,560.00
Total	3,060.00	51,060.00

Required return is 3% per month.

NPV_{Current plan} = 3,060 + 51,060 / 3% = $ 1,705,060.00

Under new policy:

Sale Price = $ 80 per unit

Sale Volume = 1,500 -150 = 1,350 units

Parameter	Now	30 days
Produce first set of 1,350 units per month at a cost per unit of $45	-60,750.00
Customers pay for 1,350 units @ 80 per unit		108,000.00
Produce next set of 1,350 units per month at a cost per unit of $45		-60,750.00
Total	-60,750.00	47,250.00

Required return is 3% per month.

NPV_{New plan} = -60,750 + 47,250 / 3% = $ 1,514,250.00

Hence, NPV of switch = NPV_{New Plan} - NPV_{Current plan} = $ 1,514,250.00 -  1,705,060.00 = - $ 190,810.00

Hence, the net present value (NPV) of making this change = - $ 190,810