Question

Locust Software sells computer training packages to its business customers at a price of $104. The cost of production (in present value terms) is $99. Locust sells its packages on terms of net 30 and estimates that about 8% of all orders will be uncollectible. An order comes in for 10 units. The interest rate is 1.4% per month.

c-1. Now suppose that if the customer pays this month's bill, they will place an identical order in each month indefinitely and can be safely assumed to pose no risk of default.Calculate the present value of the sale.

c-2. Should credit be extended?

d. What is the break-even probability of collection in the repeat-sales case?

Answer 1

I have answered the question below

Please up vote for the same and thanks!!!

Do reach out in the comments for any queries

Answer:

PV(COST) = 99

PV(REV) = 104/1.04 = 100

The expected profit from a sale is: .92(100 – 99) – .08(99) = –$7

The firm should not extend credit.

2)

A paying customer now represents perpetuity of profits of 100 – 99 =1 per month.

The present value is 1/.014 = 71.42857

So the present value of a sale, given a 8% default rate, is

.92(71.42857) – .08(99) = 57.7944

3)

It clearly pays to extend credit.

1. p(3120) – (1 – p)99 = 0

3219p – 99 = 0

p = 32.515%.