Question

A company makes only cash sales (i.e., it has no receivables). It currently sells 1,000 units per month at a sales price of $45 and a present value of costs of $35 per unit. Firm plans to allow credit sales to increase its sales to 1,100 units per month, in which case all sales will be made on credit and 5% of sales will end up being uncollectible after the 30- day payment period. If the discount rate is 1% per month, should the firm extend the credit? Assume that under credit sale, production costs were paid at the time of sale and that outstanding receivables have an average of one month

Answer 1

When 1000 units are sold

Sales (no. of units × price)= 45,000

(1,000 × 45)

(-)Cost (no. of units × cost)= (35,000)

( 1,000 × 35)

Net profit = 10,000

When Credit is given, 1100 units are sold

Sales (1,100 × 45) = 49,500

(-) Cost (1,100 × 35) = (38,500)

profit = 11,000

(-) 5% uncollectible (5% × 11,000) = 550

Net profit = 10,450

But, this money will be received after 30 days. In order to compare it , we need to discount it to get its present value.

Discounting of the profit

= 10,450 / (1+0.01)^1/12

= $10,441.34

note:- As the discount rate is already monthly so we need not divide it by 12. As we need to discount back just one month so we put the time period as 1/12.

Answer:- As the net profit by giving credit is more than without credit, So the firm should extend the credit.