Question

Consider the case of the Cast Iron Company. On each nondelinquent sale, Cast Iron receives revenues with a present value of $1,320 and incurs costs with a present value of $1,000. Cast Iron’s costs have increased from $1,000 to $1,170. Assuming that there is no possibility of repeat orders and that the probability of successful collection from the customer is p = 0.85, answer the following.

a-1. What is the expected profit of granting credit? (Do not round intermediate calculations.)

a-2. Should Cast Iron grant or refuse credit?

Grant

Refuse

b. What is the break-even probability of collection? (Enter your answer as a percent rounded to 1 decimal place.)

Answer 1

1. a). The present value of revenue generate by selling one unit of non delinquent sale of cast iron = $1,320

The present value of cost of one unit of cast iron = $1,170 assuming increase of cost

Probability of successful collection of order =0.85

Expected revenue collection = $1320 * 0.85 = $ 1122

Expected profit of granting credit is = expected revenue collection – cost of goods

                                                                        = $1122- $1170 = -$48 i.e a loss of $48 answer

2. a) Since the company is suffering a lost of $48 dollar by granting credit to the customer , so Cast Iron should refuse credit. answer

2. b) Let us assume the breakeven probability of collection = x %

expected revenue = x*$1320

So when there is a breakeven then expected profit is equal to zero

Expected profit of granting credit is = expected revenue collection – cost of goods

• 0 =expected revenue- cost
• Expected revenue = cost
• x*$1320 = $1170
• x= $1170/$1320
• x= 88.63 %

So the breakeven probability of collection is approx equal to 89% answer.