(5 Marks) Question Four Karen Shakombo wishes to apply NPV analysis to a newly r

ID: 3315156 • Letter: #

Question

(5 Marks) Question Four Karen Shakombo 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 per cent. The size of the order is shs. 3.0 million. She finds out from the management accounting department that variable costs are approximately 65 per cent of Sales and that incremental credit administration and collection expenses approach 1 per cent of Sales. Required: (a) Assuming that with perfect certainty that the customer will pay according to the it terims. Should Karen approve the order? accounts similar to the credit applicant are as follows: Payment timing Within 45 days 45-60 days 60-90 days More than 90 days (10 Marks) (b) Assume furth er research indicates that payment probabilities and timing for Probability 0.50 0.30 0.05 Assume that payments are received evenly within the above time brackets. The Company's experience is that payment received after 90 days is obtained only after referral amount of the invoice. It collects, on average, 65 per cent of invoice amount, about 1 month after referral. Before the agency referral at day 90, and after the 45 days, the Company incurs an additional sh. 125,000 collection cost every 15 days. to a collection agency The agency charges 30 per cent of the shilling Based on the expected NPV of the revised situation, should Karen recommend credit extension. (15 Marks) Page 5 of 5

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.