Question

Locust Software sells computer training packages to its business customers at a price of $104. The cost of production (in present value terms) is $96. Locust sells its packages on terms of net 30 and estimates that about 9% of all orders will be uncollectible. An order comes in for 20 units. The interest rate is 1.3% per month.

a-1). Should the firm extend credit if this is a one-time order?
1) Yes
2) No
a-2). Calculate the profit or loss if the sale will not be made unless credit is extended. (Do not round intermediate calculations. Round your answer to 2 decimal places Enter the value answer as a positive number.)
b. What is the break-even probability of collection? (Do not round intermediate calculations. Round your answer to the nearest whole percent.)
c-1). Now suppose that if the customer pays this month's bill, they will place an identical order in each month indefinitely and can be safely assumed to pose no risk of default.Calculate the present value of the sale. (Do not round intermediate calculations. Round your answer to 2 decimal places.)
c-2). Should credit be extended?
1) Yes
2) No
d. What is the break-even probability of collection in the repeat-sales case? (Do not round intermediate calculations. Enter your answer as a percent rounded to 1 decimal place.)

Answer 1

The decision to extend credit is calculated based on expected profit, which takes into account the selling price, production cost, default rate, and financing costs. For one-time orders, break-even probability of collection plays a key role, while repeat orders add future value consideration to the decision.

Step-by-step explanation:

The decision to extend credit to a customer for a one-time order can be analyzed by considering the expected profit from the transaction. Since the company will make a profit of $8 per unit (selling price of $104 minus production cost of $96) and expects a 9% default rate, the adjusted profit per unit can be calculated. Additionally, the cost of financing needs to be taken into account due to the 30-day credit terms at an interest rate of 1.3% per month. The break-even probability of collection is the minimum probability at which the expected profit is zero.

For the repeat-sales scenario where the customer will place identical orders every month indefinitely after paying the initial bill, the situation changes significantly. The present value of these sales must be calculated, considering the cost of financing and the lack of default risk after the first payment. In such a scenario, extending credit could be more favorable.