Company Z is currently selling widgets at $1,000,000 per unit, with a 75% variab

Question

Company Z is currently selling widgets at $1,000,000 per unit, with a 75% variable cost. They're considering offering credit terms, allowing payments to be delayed by 30 days. If credit terms are extended, monthly sales will increase from 5 units (currently) to 6 units (after the credit term extension); however, by providing credit, company Z predicts a 2.25% customer default rate.

At what monthly interest rate would company Z be indifferent between extending credit and continuing its current policy? Please show work

Explanation / Answer

                                            6 unit            6 units
Sales revenue                 $6,000,000      $6,000,000

Less : Variable cost 75%    $4,500,000       $4,500,000
Less : 2.5% default                                      $150,000
Total costs                       $4,500,000       $4,650,000
                                       =======================
Operating profit               $1,500,000       $1,350,000

Monthly interest rate = ($1,500,000 - $1,350,000) / $6,000,000
= 2.50% per annum OR 0.21% per month (2.50% / 12)

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