Question

SNC is considering an opportunity to add a large customer, Midwest Miracles, a recently launched weight-loss center that is in a precarious financial situation because its entrepreneurial founder took on a significant debt burden. Acquiring Midwest Miracles would allow SNC to increase sales by 30% in 2019. Some analysts have forecasted a 20% probability that Midwest Miracles will declare bankruptcy, and they estimate a recovery rate for suppliers of 50%. Midwest Miracles would be willing to pay significantly higher prices for SNC's products, which can increase the EBIT margin of the whole company by almost 1%. However, Midwest Miracles is likely to take a longer-than-average time to pay its invoices. Therefore, SNC's DSO is likely to increase significantly. What would you like to do about this opportunity?

2019 2020 2021
Incrementa Income ($ in thousands)
Summary Statement
Change in Sales $8,439 $8,439 $8,439
Change in Cost of Sales $7,523 $7,523 $7,523
Change in EBIT $916 $916 $916
Incremental Balance Sheet
($ in thousands)
Change in Accounts
Receivable $4,309 $4,309 $4,309
Change in Inventories $1,907 $1,907 $1,907
Change in Accounts Payable $817 $817 $817

Answer 1

Even without calculating any extra costs related to the long collection time of Midwest Miracles's invoices, the expected value of selling products to them is negative. This means that if SNC sells products to Midwest, they should expect to lose money. That doesn't make any sense at all, therefore, SNC should not take this opportunity.

The reason why Midwest Miracles is willing to pay a higher price than other retailers is simple, they are desperate. They will do anything to try to save themselves, even if it means hurting other companies if they fail to do so.

The reason why a good credit score lowers interest rates, while a terrible credit score means that no bank will lend you any money is simply, businesses are risk averse. That is why no bank lends any money to Donald Trump. He has filed for bankruptcy so many times that no bank will risk lending money to him.

Angel investors take this type of risks, but if they are successful, a $200,000 investment may result in a $10 billion gain. In this case, you have to choose between losing a lot of money and earning a much smaller amount. Accepting this type of clients will soon make SNC file for bankruptcy itself.

Step-by-step explanation:

If Midwest Miracles declares bankruptcy, then SNC will lose $8,439,000 x 50% (recovery rate for suppliers) = $4,219,500. If it doesn't declare bankruptcy, then SNC will make additional profits of $916,000 per year.

We must determine the expected value of MW's operation:

expected value = (-$4,219,500 x 20%) + ($916,000 x 80%) = -$843,900 + $732,800 = -$111,100