The firm is considering a proposal to extend credit to a new customer on an orde
ID: 2766875 • Letter: T
Question
The firm is considering a proposal to extend credit to a new customer on an order totaling $75,000. The contribution margin on the order is 12.5%. The company will incurs half the costs associated with the order immediately and the other half when the order is delivered in 90 days. Payment is due 30 days after delivery. The firm believes there is an 80% chance the customer will make payment on the order (i.e., a 20% chance the account will be uncollectible). If payment is not made, the company does not expect to be able to recover any of its costs. The company’s cost of capital (i.e., its required return) for this proposed transaction is 20%.
1. What is the expected cash outflow from this order and when will it occur?
2. What is the expected cash inflow from this order and when will it occur?
3. What is the expected net present value of this order?
4. Will the company accept this order?
Explanation / Answer
1. What is the expected cash outflow from this order and when will it occur?
Expected Cash outflow of (75000*0.875/2) 32812.50 incurred immediately and expected cash outflow of 32812.50 incurred after 90 days.
2. What is the expected cash inflow from this order and when will it occur?
Expected Cash inflow of (75000*0.80) 60000 occurs after 120 days.
3.
I = 20*(90/360)
= 5
Present value of expected cash outflow(A) = (75000*0.875/2)+(75000*0.875/2)/(1.05)
= 32812.5+ 31250
= 64062.5
I = 20*(120/360)
= 6.67
Present value of cash inflow (B) = 60000/1.0667
= 56248.24
Expected net present value of this order =(B)-(A)
= 56248.24-64062.5
= -7814.26
4. The company should not accept this order as NPV is negative.
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