Question

a) Zoey Enterprises manufactures solar engines for helicopters. Given the fuel savings available, new orders for 125 units have been made by customers requesting credit. The variable cost is $11,400 per unit, and the credit price is $13,000 each. Credit is extended for one period. The required return is 1.9 percent per period. If Zoey Enterprises extends credit, it expects that 30 percent of the customers will be repeat customers and place the same order every period forever, and the remaining customers will place one-time orders. Should credit be extended?

b) Now, assume that the probability of default is 15 percent. Should the orders be filled now? Assume the number of repeat customers is affected by the defaults. In other words, 30 percent of the customers who do not default are expected to be repeat customers.

Answer 1

Cost today = $11400 per unit

NPV of Profit (after one period) =125* ( -11400 + 13000/1.019) = $169700.69

NPV of Profit in each subsequent period is $169700.69*0.3 =$50910.21

NPV today = 169700.69 + 50910.21/1.019^1+...+

= (169700.69+ 50910.21/0.019)

=$2,849,185.43

As NPV is positive, credit should be extended if there are no bad debts losses.

b) Expected no. of units for which amount will be received = 85% of 125 = 106.25 units

profit in the 1st period = 106.25 * (13000-11400*1.019) - 18.75*(11400*1.019)

= - $70825

30% will be repeat customers in every period. Assuming that there will be no default in the repeat customers

Net profit due to repeat orders after 1st period = 106.25*0.3*(13000-11400*1.019)/0.019 = $2320835.53

So, NPV today = (2320835.53-70825)/1.019 = $2,208,057.44

As NPV is positive, orders should be filled now.