Question

A customer applies for credit at your firm. Your terms are net 35 days. The customer’s D&B report reveals that he pays on the net date only 10% of the time. He pays 30 days late 60% of the time, he pays 60 days late 20% of the time, and he pays 90 days late 10% of the time (with necessary assistance being provided by a collection agency). The item he wishes to buy has an invoice price of $2,000 and your variable cost is $1,850. Your credit administration/collection costs are $30 per month, beginning when an invoice has passed its net date. After referral to the collection agency, the collection agency keeps 30% of all funds collected as its fee. Your annual cost of capital is 11%. Should you grant credit to this applicant?

Answer 1

This problem is based on probability of realizing payoffs for different situations mentioned in the problems:

Let's calculate payoffs one by one assuming the collectionagency is required after the payment is delayed.

1) if the payer pays on time (Net date)

then money realized=$2000-$1850=$150

2) if the payer pays after 30 days:

Money realized=2000-1850-30-0.30*2000=-$480

3) if the payer pays after 60 days:

Money realized=2000-1850-30*2-).30*2000=-$510

4) if the payer pays after 90 days:

Money realized=2000-1850-30*3-).30*2000=-$540

Therefore expected gain/loss=0.1*150+.6*(-480)+0.2*(-510)+0.1*(-540)=-$429

This is showing negative returns if the there is not charge of interest from credit firm on delayed payments, and if that is the case it's clear that the credit firm will not give the credit.