Question

Phoenix Lambert currently sells its goods cash-on-delivery. However, the financial manager believes that by offering credit terms of 2/10 net 30, the company can increase sales by 20%, without significant additional costs. If the interest rate is 6% and the profit margin is 8%, would you recommend offering credit? Assume first that all customers take the cash discount. Then assume they all pay on day 30.

Joe’s hint: I would start by assuming the company has $100 in sales, and then calculate the PV of profits for all three scenarios: no credit (as it is right now with cash only), credit in which everyone takes the discount, credit in which everyone pays as late as possible.

Answer 1

Scenario 1: PV of profit when there is no credit:

Here there would no increase in sales since there is no discount, So Sales will reamin to be at $100. So profit will be 8% of sales = 0.08*100 =$8

So, PV of profit = 8/0.06 = 133.33

Scenario 2: PV of profit when credit is offered and all customers take discount

Sales will increase by 20%, So new sales will be 1.20*100 = $120

Since everyone takes a discount of 2%, actual Sales will be 120*(1-0.02) = 117.6

Profit will be =0.08*117.6 = 9.408

PV of profit = 9.408/0.06 = 156.8

Scenario 3: PV of profit when credit is offered and all customers pay late

Sales = 120. There is no discount here

Profit = 120*0.08 = 9.6

PV of profit = 9.6/0.06 = 160

As we can see the the Present value of profit is higher when credit is offered irrespective of discount. So, I would recommend offering the credit