Tricia Velasquez wishes to apply NPV analysis to a newly received order. The com

ID: 2739814 • Letter: T

Question

Tricia Velasquez wishes to apply NPV analysis to a newly received order. The company's credit terms are net 45 days. Its opportunity cost of funds is 12 percent. The order dollar amount is $30,000. She finds out from the cost accounting department that variable costs are approximately 65 percent of sales and that incremental credit administration and collection expenses approach 1 percent of sales.

a. Assuming that the customer will pay according to the credit terms, with perfect certainty, should Tricia approve the order?

b. .Assume that further research indicates that payment probabilities and timing for accounts similar to the credit applicant are as follows:

Assume that payments are received evenly within the above time brackets. Th e company's experience is that payment received aft er 90 days is gotten only after referral to a collection agency. Th e agency charges 30 percent of the dollar amount of the invoice. It collects, on average, 65 percent of the invoice amount, about one month aft er referral. Before the agency referral at day 90, and aft er the 45 days, the company incurs an additional $125 collection cost every 15 days. Based on the expected NPV of the revised situation, should Tricia recommend credit extension?

Please show all calculation on a excel spreadsheet.

PAYMENT TIMING PROBABILITY Within 45 days 0.50 45-60 days 0.30 60-90 days 0.15 Over 90 days 0.05

Explanation / Answer

Credit terms = 45 days

Opportunity cost = 12%

Cost per day =

Amount of invoice = $30,000

Variable cost = 65% * 30000 = $19500

Credit administration and collection cost = 1% of sales

Net gain (NPV) = Sales - Cost - Collection cost - Opportunity cost = 30000 - (30000*.65) - (30000*.01) - (30000*.12*45/365) = 9756.16

So, order should be accepted as it has positive NPV

Payment Probability

Net Cash Flow

Additional Cost

PV factor

NPV

NPV as per Probability

0.5

29700

0.993

29481.915

9981.9146

4990.9573

0.3

29575

125

0.983

29073.189

9573.1888

2871.9566

0.15

29325

250

0.976

28619.318

9119.3182

1367.8977

0.05

9950

9250

0.962

9572.3511

-9927.649

-496.3824

Total NPV = $8734.4292

Expected collection: The range of expected collection is half of the range mentioned, like 22.5 for range 045, 52.5 is half of the range 4560etc

Additional cost There are no collection costs for payment in 45 days or less; for 52.5days, however, the additional collection costs (beyond the 1% * $30,000) are$125; for 75.5 days

the additional collection costs (beyond the $300) double to$250; after 90 days, the additional collection costs cumulate to the $250 plus the30% of the referred amount of $30,000 (= $9,000) for a total of $9,250 in additional charges beyond the original $300.

Net Cash: the $9,950 = 0.65 * $30,000 (the percent of the referred amount collected by the agency = $19,500) less the agency's charge of 30% (=$9,000!), less the $250 accrued additional collection costs, less the 1% EXP * S of $300.

Considering the NPV of the uncertain case, it can be said that the company has positive NPV, so the credit should be extended.