Question 19.4: Your company currently sells its product with a 1% discount ...
Your company currently sells its product with a 1% discount to customers who pay cash immediately. Otherwise, the full price is due within 30 days. Half of your customers take advantage of the discount. You are considering dropping the discount so that your new terms would just be net 30. If you do that, you expect to lose some customers who were only willing to pay the discounted price, but the rest will simply switch to taking the full 30 days to pay. Altogether, you estimate that you will sell 20 fewer units per month (compared to 500 units currently). Your variable cost per unit is $60 and your price per unit is $100. If your required return is 1% per month, should you switch your policy?
PLAN
To decide whether to change your policy, compute the NPV of the change. It costs you $30,000 to make the 500 units. You receive payment for half of the units Immediately at a price of $99 per unit (1% discount). The other half comes in 30 days at a price of $100 per unit. At that point, you are starting over again with the next set of product. Thus, you can think of your cash flows in any 30-day period as:
Under the new policy, your cash flows would switch to:
With these cash flows, we are ready to compute the NPV of the policy change.
EXECUTE
NPV_{current}=-5250+\frac{25,000-5250}{.01}=1,969,750NPV_{new}=-28,800+\frac{48,000-28,800}{.01}=1,891,200
So the NPV of the switch will be $1,969,750 – $1,891,200 = –$78,550.
EVALUATE
You shouldn’t make the switch because you will lose too many customers, even though your remaining customers will be paying the full price. The NPV helps us weigh this tradeoff—the present value of the costs outweighs the present value of the benefits, so the decision is not a good one.
| Now | 30 days | |
| Produce first set of 500 units at $60 apiece | –30,000 | |
| Customers pay for 250 units at $99 apiece | +24,750 | |
| Customers pay for 250 units at $100 apiece | +25,000 | |
| Produce next set of 500 units at $60 apiece | –30,000 | |
| Customers pay for 250 units at $99 apiece | +24,750 | |
| Total | –5,250 | +25,000 – 5,250 |
| Now | 30 days | |
| Produce first set of 480 units at $60 apiece | –28,800 | |
| Customers pay for 480 units at $100 apiece | +48,000 | |
| Produce next set of 480 units at $60 apiece | –28,800 | |
| Total | –28,800 | +48,000 – 28,800 |