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Credit Decision/Repeat Sales

Locust Software sells computer training packages to its business customers at a price of $101. The cost of production (in present value terms) is $96. Locust sells its packages on terms of net 30 and estimates that about 7 percent of all orders will be uncollectible. An order comes in for 20 units. The interest rate is 1 percent per month.

a. Should the firm extend credit if this is a one-time order? The sale will not be made unless credit is extended.

b. What is the break-even probability of collection?

c. Now suppose that if a customer pays this month's bill, it will place an identical order in each month indefinitely and can be safely assumed to pose no risk of default. Should credit be extended?

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

Solution Preview

a. Should the firm extend credit if this is a one-time order? The sale will not be made unless credit is extended.

In order to make the decision, we need to calculate the expected profit from the sale. If the sale is made, we collect $101 in 1 month, given an interest rate of 1% per month, the present value of collection is 101/(1+1%) = $100. The present value of cost price is $96. The sale would result in a profit of (100-96) = $4. The possibility of ...

Solution Summary

The solution explains how to decide whether credit should be offered - if it is a one time sale or repeat sales

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