Question

Creative Genius (CG) sells science kits for children for $35 and has been doing very well for the last three years. The Vice President of Sales has asked the Credit Manager to review the company’s policies with regards to extending credit. You are given the following information: Currently, CG uses terms of net 30, and the Collections manager indicates that the uncollectible estimate is 4%. The interest rate per month is 1% and the present value of the costs of production are $21. Required: 1

. Creative Genius wants to know if it should be extending credit to one-time orders?

2. What is the break-even probability of collections?

3. If Mad Scientist, a new customer, wants to place recurring monthly orders, and their credit check determines that they are not a default risk, should credit be extended?

4. What is the break-even probability of collections for Mad Scientist?

Please show all work and formulas

Answer 1

Given Facts about Creative Genius                                                                        

Current selling price of Science Kits = 35$                                                                              

Current pay terms = net 30                                                                          

Uncollectible estimates by collection manager = 4 %                                                                       

Present Value of cost of Production = 21$                                                                             

Rate of Interest per month = 1%                                                               

                                                                               

Requirement 1

The decision for extending credit is based on the risk that the company is ready to face in the creditors fails to pay. In order to take that decision, a proper estimation work about the Uncollectible and the risk that the company is ready to take should be done. The risk that the company is ready to take is the extent that the company is ready to bear uncollectible usually until the total profits become zero. This is represented by Break-even probability of collections. If (1-break-even probability of collections) > Uncollectible Estimates, then credit can be extended.                                                               

Since the (1-Break-Even Probability of Collections(p)) i.e., 39.39% for one time orders which is calculated in 2nd step is more than uncollectible estimates, Creative Genius can extend credit period.                                                    

                                                                               

                                                                               

Requirement 2

For one time orders, Break-Even Probability of Collections(p) = Present Value (COST) / Present Value (Revenue)                                                                

                                                                               

Required Inputs                                                                              

Given that the Present Value of cost of Production = 21$                                                                               

Present Value of Revenue is calculated as follows                                                                             

Present Value of Revenue = Selling Price/ (1+Rate of Interest for the period)                                                                        

                                = 35$/ (1+0.01)                                

                                $34.65                                

                                                                               

substituting the values in main Formula, we get                                                                

Therefore Break-Even Probability of Collections(p) = 21/34.65 = 060601

                                                                               

Hence Break Even probability of Collection = 0.6061                                                                      

This means, there should be at least 60.61% probability of collections should be there in order to not incur loss due extension of credit period.                                                                          

Hence Creative Genius can bear defaulted credit of 39.39% without incurring losses                                                                         

                                                                               

                                                                               

Requirement 3

Mad Scientist who wants to place recurring monthly orders has no default risk. Besides that, (1 - Break-Even Probability of Collections) in case of continuous orders which is calculated in step 4 i.e., 39.76 % is more than uncollectible estimates 4%. Hence credit can be extended to Mad Scientist.   

                                                                               

Requirement 4

The probability(p) which makes the expected profits zero because of granting credit is called the Break-Even Probability of Collections.                                                                            

It is formalised as follows                                                                             

[p*Present Value (Revenue – Cost)]– [(1-p)* Present Value(Cost)] = 0                                                                      

                                                                               

Required Inputs                                                                              

Given that the Present Value of cost of Production = 21$                                                                               

Present Value (Revenue-Cost) is calculated as follows:

Present Value of (Revenue-Cost) = (Selling Price - Cost)/(1+Rate of Interest for the period)            

=(35$ - 21 $)/(1+0.01)

=$13.86                                                                               

substituting the values in main Formula, we get                                                                              

p*(13.86)-(1-p)*(21) = 0                                                               

13.86p-21+21p = 0                                                                          

34.86p = 21                                                                        

p = 21/34.86 = 0.6024                                                    

                                                               

                                                                               

Hence Break Even probability of Collection = 0.6024                                                                         

This means, there should be atleast 60.24% probability of collections should be there in order to not incur loss due extension of credit period.                                                                          

Hence Creative Genius can bear defaulted credit fault of 39.76% without incurring losses