Algebra Ltd is selling inventory management software for small to mid-size firms

Question

Algebra Ltd is selling inventory management software for small to mid-size firms. Currently, the computer program is sold only for cash. In order to increase its revenues, the company is considering the alternative of offering a credit for one month to all of its customers. However, by providing customer credit, the company expects that it will incur the risk of attracting high-risk customers that could default on their payments. The two strategies are outlined below:

1 The $5 difference is unit cost reflects the cost of managing the credit policy

Algebra Ltd cost of capital is 1 percent per month

a. What is the net present value (NPV) of selling the computer program for cash?

b. What is the NPV selling the computer program on credit?

c. What should Algebra do?

Cash-based sales Credit Sales Unit Sales Price $100 $100 Quantity sold 100 100 Cost per unit $50 $551 Probability of customer defaulting 0 percent 10 percent

Explanation / Answer

a)  net present value (NPV) of selling the computer program for cash

= (100-50)*100/0.01

=5000/0.01

=500,000

b)the NPV selling the computer program on credit

=(100-55)*100*(1-0.10)/0.01

=4500*0.90/0.01

=405,000

c) Since the NPV of selling the computer program on credit(405,000)< (NPV) of selling the computer program for cash(500,000)

therefore its more profitable for Algebra to follow Cash-based sales strategy.

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