Question 20A.S-TP.2: Discounts and Default Risk The De Long Corporation is consid...
Discounts and Default Risk The De Long Corporation is considering a change in credit policy. The current policy is cash only, and sales per period are 2,000 units at a price of $110. If credit is offered, the new price will be $120 per unit, and the credit will be extended for one period. Unit sales are not expected to change, and all customers are expected to take credit. De Long anticipates that 4 percent of its customers will default. If the required return is 2 percent per period, is the change a good idea? What if only half the customers take the offered credit?
The costs per period are the same whether or not credit is offered; so we can ignore the production costs. The firm currently has sales of, and collects, $110 × 2,000 = $220,000 per period. If credit is offered, sales will rise to $120 × 2,000 = $240,000.
Defaults will be 4 percent of sales, so the cash inflow under the new policy will be .96 × $240,000 = $230,400. This amounts to an extra $10,400 every period. At 2 percent per period, the PV is $10,400 /.02 = $520,000. If the switch is made, De Long will give up this month’s revenues of $220,000; so the NPV of the switch is $300,000. If only half of the customers take the credit, then the NPV is half as large: $150,000. So, regardless of what percentage of customers take the credit, the NPV is positive. Thus, the change is a good idea.